a) Compute ROE and the sustainable growth rate. How is EPS related to Roe? Deriv
ID: 2646221 • Letter: A
Question
a) Compute ROE and the sustainable growth rate. How is EPS related to Roe? Derive EPS
b) Derive the operating free cash flow and free cash flow to equity . Additionally, compute the price of the stock according to both definitions. Assume the growth rate for both is the same as in problem one, and that it is constant and perpetual. We know that cost of debt is 5% after taxes and the weight of debt is 40%. The cost of equity is 15%.
income statement 1998 1999e Revenue $4,750 $5,140 Cst of Goods Sold $2,400 $2,540 Selling, General, and administrative 1,400 1,550 Depreciation 180 210 Goodwill amortization 10 10 Operating Income $760 $830 Interest Expense 20 25 Income before Taxes $740 $805 Income Taxes 265 295 Net Income $475 $510 Earnings per share $1.79 $1.96 Average shares outstanding (millions) 265 260 Balance Sheet Cash $400 $400 Accounts receivable $680 $700 Inventories $570 $600 Net property, plant, and equipment $800 $870 Intangibles $500 $530 Total assets $2,950 $3,100 Current liabilities $550 $600 Long-term debt $300 $300 Total liabilities $850 $900 Stockholders' equity $2,100 $2,200 Total liabilities and equity $2,950 $3,100 Boook value per share $7.92 $8.46 Annual dividend per share $0.55 $0.60Explanation / Answer
(a) Computation of Return on investment(ROE) and the sustainable growth rate.We have,
ROE = Net Income after tax / Shareholder Equity
Computation of sustainable growth rate.We have,
Sustainable growth rate = (510 - 475) / 475 x 100 = 7.37 %
Hence, the Sustainable growth rate is 7.37 %.
Earning per share is also calculated Net profit after tax divided by total number of shares. Hence it is related to ROE because ROE is also calculated by dividing Number of shares multiply by paid up share capital.
(b) Free cash flow = CFO - capital expenditures. and
Free Cash flow of Equity = Net Income + Non-Cash income - Capital Expenditures + Net Borrowings.
Particulars 1998 1999 Net income after tax 475 510 Shareholder Equity 2,100 2,200 Return on Equity ( ROE) 22.62 % 23.18 %Related Questions
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