SMG AC 414 Study Guide - Midterm Guide: Income Statement, Asset Turnover, Treasury Stock

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Decomposing ROE

 
   
Earnings generated from b. NOA
   
After tax cost arising b. Net Debt
    
     
Operating effects driven by sales growth Financing effects driven by leverage
Valuation
Value of firm: PV of Net Debt (int and principal) + Equity (div and repurch)
Value of equity: PV of Equity (div and repurch)
DDM
Uses PV of divs
Wealth distribution
DCF
PV of FCFs;
Assumes div irrelev.
RI “abnormal earnings”
Creation of wealth
I/S and B/S forecast
  
o Implies: NI > 0 not sufficient for firm to create value
o Drivers for relative magnitude of NI vs. 
CA, price premium, sustainability
Long term: competition forces residual income to 0
o NI = Re*BEt-1 ROE re terminal value 0 (eventually)
TV
Largest for DDM, DCF; not RI bc RI only forec. abnormal earnings
If we believe firms in steady state (ROE and g will be stable)
o  
 ; 

Sales growth in perpetuity 5%; cost of capital 9%; interest on cash = 0%
implied by TV: can cont. to earn substantial RI into the future
Dec in BVE from 10 (704) to 11 (662): implied div or share repurch of
222 (firm generating more can than it can deploy)
P/B multiple
Primary rep: Steady state:
 

3 components drive PB:
o Expected ROE relative to re (“Equity Spread”)
Future ROEs > re P/B > 1
Future ROEs = re P/B = 1
Future ROEs < re P/B < 1
o Growth in BV
o Cost of equity capital
PE Multiple
Driven by same factors that drive PB multiples
PE also affected by current earnings (i.e., 1/ROE0)
o All else equal
Higher c. earnings higher c. ROE lower P/E
Lower c. earnings lower c. ROE higher P/E
P/B
LOW
HIGH
P/E
LOW
Low future ROE
Low growth in
earnings
Low future ROE
Low growth in
earnings
HIGH
Low future ROE
Low growth in
earnings
Low future ROE
Low growth in
earnings
‘Clean Surplus’ Accounting:  
Dirty Surplus’ Accounting:  
THG stock price has recently gone up, and the company is
considering reselling $900M of its T/S for after-tax proceeds of
$1,000M. What would be THG’s revised net debt and return on
equity if the company completed that transaction?
(i)Net Debt after stock resale
1,138 - 1,000 = 138 [cash goes up, i.e., ND goes down by 1,000]
(ii)Return on Equity after stock resale
389 / (926 + 1,000) = 389 / 1,926 = 20.2% [treasury stock goes
up by 900, additional paid-in capital by 100]
0=1
(1+ )1+2
(1+ )2=
(1+ )
=1
0=1
(1+)1+2
(1+)2=
(1+)
=1
( )
=
+
+=
1
0
1
0
0
1
1
t
t
e
t
et
r
BVE
BVE
rROE
BVE
P
)(
ROE = NOPAT x S + NOPAT -
Int After Tax
x Net Debt
S Net TA Net TA Net Debt E
Margin Turnover Leverage
Operating ROA
Spread
Financial Leverage
ROE = NI x S x TA
STA E
Margin Turnover Leverage
Dupont
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