The quarterly investors call is approaching and you were asked to comment on the

Question

The quarterly investors call is approaching and you were asked to comment on the EPS and projected EPS based on the growth forecast of 10%.

(a) Compute the EPS for the calendar year of 2016

(b) What is the projected EPS with 10% sales growth?

You are a bit skeptical of the projected 10% growth in sales and decided to look at a much less aggressive long-run growth scenario of 3.5% growth in sales.

(c) What is the projected EPS for a 3.5% growth in sales? If the dividend payout ratio remains the same, how much is paid per share?

As some external financing will be needed to accommodate any growth, you started looking into raising debt and/or equity. Since your company would be mostly described as a small- cap US company, you looked at market data to help you determine your costs of equity and debt.

(d) What should be the risk premium for appropriate market for your company? Assume the risk free is given by 1mo Treasury Bills.

(e) Looking at historical stock market data, you determined that your beta is roughly 1.4 with respect to the market benchmark you used above to compute the risk premium. What should your cost of equity be?

(f) In order to get a little more comfortable with the number computed above, you decided to look at the cost of equity using the dividend growth corresponding to the 3.5% growth scenario from (c). What is the cost of equity using this approach?

In order to determine your cost of debt, you decided to look at your long term debt, which is structured as a single 20yr bond with semi-annual coupons, a coupon rate of 10%, and is currently trading at 105%.

(g) What is your cost of debt?

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(h) What is your after-tax cost of debt?

Your CEO is interested in knowing what is the minimum return the company should generate to make sure investors are satisfied, but is not sure which number to focus on.

(i) What measure should you propose and how would you explain it to your CEO? (j) What is the value for the proposed measure?

Income Statement 2016 Sales $43,000,000 Taxes: 40% COGS $30,000,000 Other expenses $5,000,000 Shares Outstanding 1,000,000 Depreciation $2,000,000 Market-to-Book Ratio 1.25 EBIT $6,000,000 Interest $2,000,000 Taxable income $4,000,000 Taxes (40%) $1,600,000 Net income $2,400,000 Dividends $600,000 Add to RE $1,800,000 Balance Sheet, Dec 31, 2016 Assets Liabilities & Owners’ Equity Current Assets Current Liabilities Cash $500,000 Accounts Payable $1,000,000 Accounts Receivable $1,000,000 Notes Payable $3,000,000 Inventory $2,000,000 Total CL $4,000,000 Total CA $3,500,000 Long Term Debt $10,000,000 Fixed Assets Owners’ Equity Net PP&E $25,000,000 Common Stock $6,500,000 Retained Earnings $8,000,000 Total Equity $14,500,000 Total Assets $28,500,000 Total L & OE $28,500,000

Explanation / Answer

Part (a) Since the net income for 2016 has already been computed, the EPS can be computed by dividing the net income by number of shares outstanding (both the parameters are already given to us.

The EPS for the year 2016 is $2.40 ($2,400,000/1,000,000).

Part (b)

Projected EPS with 10% growth is computed below:

The EPS for 2017 computed as above is $2.88 per share.

Notes:

1. COGS & other expenses have been taken as a fixed percentage of sales (computed as per financials for 2016)

2. Depreciation & Interest Expense has been assumed as the same as per 2016 since no capacity expansion has been carried out.

Part (c)

Here sales have grown by 3.5%. All assumptions for expenses have been taken the same as above. EPS computed in this case is $2.57.

Part (d)

Since the company is a US Small Cap, The S&P Small Cap 600 Index may be taken to be the relevant Benchmark for the Company.

The YTD Return from the S&P Small Cap 600 Index is 13.23%, while the 1 month US Treasury yield is 1.256%

Thus, as per CAPM the Market Risk Premium will be: 13.23%-1.256%= 11.974%.

Hope that helps you out!

Don't forget to upvote!

Income Statement 2016 Sales $43,000,000 COGS $30,000,000 Other expenses $5,000,000 Depreciation $2,000,000 EBIT $6,000,000 Interest $2,000,000 Taxable income $4,000,000 Taxes (40%) $1,600,000 Net income $2,400,000 EPS (Net Income/Shares outstanding) $2.40 Dividends $600,000 Add to RE $1,800,000

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