Tutorial 9 9) a) Current P/E (share price/historic EPS) of 10x ($6.00/$0.60) – only fairly valued based on 20x2 historic EPS.

However, investors should be forward looking and assess the potential return by looking at the prospective P/E. Based on a forecast 20x3 EPS of $0.70, the current share price of $6.00 is a on a prospective PE of 8.6x. This is below its ‘normal’ P/E of 10x and near the low of its range of 8x to 12x. The shares are currently undervalued and should be bought if the investor has at least a one-year holding period. b) Several variables have been found useful in “explaining” P/E’s, namely: (Fair value formula) “Po” = D1/E1 E1 k - g Variable i) ii) iii) iv) v) expected 5-year growth in earnings dividend payout ratio sales stability institutional stock ownership financial leverage/use of debt stable P/E

For point v) assumed the starting point was a reasonably leverage company. If student says P/E goes up with rising financial leverage – ask for reasoning – if student assumes starting point was low/ zero leverage, agree as this would increase ROE without increasing financial risk. 10) Such companies trade at low PEs because shareholders generally disapprove of company management hoarding too much cash just to give themselves financial comfort (i.e. lots of cash on the balance sheet means management don’t have to worry too much about potential for financial difficulties if the company is not properly managed. They prefer management try to maximise the company’s ROE/ROA to the benefit of shareholders. Holdings cash does not maximise ROA as it is a low risk/low return asset. Cash in excess of business needs should be returned to shareholders, via higher dividend payouts or share buybacks, who can themselves, try to seek a higher return investment than leaving it in the form of cash.

Investors invest in shares because they are comfortable with the higher risk (vs. holding cash) associated with a company’s business risk.

11) a) New total assets = $500m + $150m = $650m New equity = $200m + $150m = $350m New no. of shares = $50m +$20m = $70m New EBIT = ROA x Total assets = 15% x $650m = $97.50m Less interest expense = 7.5% x $300m = ($22.50m) Pre-tax profit = $75.00m Tax = 20% x pre-tax profit ($15.00m) Net profit = $60.00m EPS = net profit/no. of shares = $60.00m/70m = $0.86 New share price = P/E x EPS = 11 x $0.86 = $9.46 b) Net total assets = $500m + $150m = $650m New borrowings = $300m + $150m = $450m New EBIT = ROA x Total assets = 15% x $650m = $97.50m Less interest expense - on current loans = 7.5% x $300m = ($22.50m) - on new loans = 10% x $150m = ($15.00m) Pre-tax profit = $60.00m Tax = 20% x pre-tax profit = ($12.00m) Net profit = $48.00m EPS = net profit/no. of shares = $48.00m/50m = $0.96 New share price = P/E x EPS = 9 x $0.96 = $8.64 c) Investors would view the issue of new shares more favourably as it is expected to lead to a higher share price. d) Debt-equity ratio (if issue new shares) = $300m/$350m = 0.86x As the debt equity ratio will drop from above 1.50x to 0.86x (i.e. slightly below industry average), Zebra’s financial risk will be perceived to be lower and thus lead investors to place a higher P/E as its shares.

Debt-equity ratio (if take on more borrowings) = $450m/$200m = 2.25x As the debt equity ratio, which is already above industry average, will become even higher, Zebra’s financial risk will be perceived to be even higher and thus lead investors to place an even lower P/E on its shares.