You have been asked to rank the following 5 companies from cheapest to most expe
ID: 2483483 • Letter: Y
Question
You have been asked to rank the following 5 companies from cheapest to most expensive on the basis of multiples of earnings. They are all in the same sector, have roughly the same expected growth in income in their operating businesses, have similar debt ratios and generate similar returns on equity on their operating investments. You have been given the following information on the companies:
Company
Price/share
# Common Shares (Primary)
# Options
Value/option
Cash Balance
Net Income
Income from Cash
A
$8.00
25
1
$2.00
$22.00
$16.00
$1.60
B
$15.00
5
2
$5.00
$10.00
$6.50
$0.50
C
$42.50
40
20
$30.00
$300.00
$170.00
$10.00
D
$7.90
10
8
$2.00
$5.00
$7.50
$0.30
E
$50.00
300
20
$20.00
$2,900.00
$1,125.00
$125.00
All of the values are in millions except for the price/share. The primary shares refer to actual shares outstanding and the value per option has been computed using an option pricing model.
1.Compute the primary PE ratio for each company and rank the companies based upon the primary PE.
2.Compute the fully diluted PE ratio for each company and rank the companies based up the fully diluted PE. Explain why the rankings change from the primary PE rankings.
3.Compute a PE ratio that incorporates the options outstanding more appropriately (than the fully diluted approach) and rank the companies based upon this ratio. Explain why the ranking change from the fully diluted PE.
4.Compute a PE ratio that incorporates both the options outstanding and the cash balances at each of the companies and rank the companies based upon this ratio. Explain why the ranking changes from the ratios that you computed in part 3.
Company
Price/share
# Common Shares (Primary)
# Options
Value/option
Cash Balance
Net Income
Income from Cash
A
$8.00
25
1
$2.00
$22.00
$16.00
$1.60
B
$15.00
5
2
$5.00
$10.00
$6.50
$0.50
C
$42.50
40
20
$30.00
$300.00
$170.00
$10.00
D
$7.90
10
8
$2.00
$5.00
$7.50
$0.30
E
$50.00
300
20
$20.00
$2,900.00
$1,125.00
$125.00
Explanation / Answer
1.Primary PE ratio for each company and ranking of companies based upon the primary PE. Formula Market price per share/ Earnings /share Company Net Income Common Shares (Primary) Primary or Basic EPS Price/share P/E Ratio Rank A 16 25 0.64 8 12.5 2 B 6.5 5 1.3 15 11.54 3 C 170 40 4.25 42.5 10 5 D 7.5 10 0.75 7.9 10.53 4 E 1125 300 3.75 50 13.33 1 2.Fully diluted PE ratio and ranking of companies based on the fully diluted PE. Company Options Value/option Total options value(Mn) Price/share Options that can be exercised(no.of shares) Common Shares (Primary) Total shares O/s Net Income Diluted EPS Price/share P/E Ratio Rank A 1 2 2 8 250000 25000000 25250000 16 0.633663 8 12.63 5 B 2 5 10 15 666667 5000000 5666667 6.5 1.147059 15 13.08 3 C 20 30 600 42.5 14117647 40000000 54117647 170 3.141304 42.5 13.53 2 D 8 2 16 7.9 2025316 10000000 12025316 7.5 0.623684 7.9 12.67 4 E 20 20 400 50 8000000 300000000 308000000 1125 3.652597 50 13.69 1 As the no.of shares increases if all the o/s options are exercised, EPS is diluted. Hence rankings change 3.PE ratio that incorporates the options outstanding more appropriately (than the fully diluted approach) and ranings based on this P/E Ratio Company Options that can be exercised(no.of shares) Options Incremental no.of shares Common Shares (Primary) Total shares O/s Net Income Diluted EPS Price/share P/E Ratio Rank A 250000 1000000 750000 25000000 25750000 16 0.62136 8 12.88 4 B 666667 2000000 1333333 5000000 6333333 6.5 1.02632 15 14.62 2 C 14117647 20000000 5882353 40000000 45882353 170 3.70513 42.5 11.47 5 D 2025316 8000000 5974684 10000000 15974684 7.5 0.46949 7.9 16.83 1 E 8000000 20000000 12000000 300000000 312000000 1125 3.60577 50 13.87 3 EPS is distributed only to the incremetal no.of shares(difference between no.of options exercised and shares that could have been purchased. Hence denominator decreases when Net income(Numerator) remains the same. Accordingly, rankings change. 4. PE ratio that incorporates both the options outstanding and Income from cash balances and rankings based on this P/E Ratio Company Options that can be exercised(no.of shares) Options Incremental no.of shares Common Shares (Primary) Total shares O/s Net Income Income from Cash Total of Net Income & Income from cash Diluted EPS Price/share P/E Ratio Rank A 250000 1000000 750000 25000000 25750000 16 1.6 17.6 0.68350 8 11.70 4 B 666667 2000000 1333333 5000000 6333333 6.5 0.5 7 1.10526 15 13.57 2 C 14117647 20000000 5882353 40000000 45882353 170 10 180 3.92308 42.5 10.83 5 D 2025316 8000000 5974684 10000000 15974684 7.5 0.3 7.8 0.48827 7.9 16.18 1 E 8000000 20000000 12000000 300000000 312000000 1125 125 1250 4.00641 50 12.48 3 Rankings are the same as in 3. There are compensating changes to net income-when income from cash is added. Denominator- no.of shares(diluted) remaining the same.
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