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Learning Objective:

To develop students’ understanding concerning the concept of financial leverage and its impact on a firm’s returns

 

Learning Outcome:

After attempting this GDB, the students will be able to comprehend the idea that how Return on Equity and Total Return to Investors is influenced upon converting an un-levered firm into a levered firm.

 

Case:

ABC is an all equity based firm having total assets of Rs.10 million invested equally by the ten members of the firm. Later; five of the members decided to leave the firm with the idea of investing their money into other businesses of their varying interest. The firm takes a bank loan of Rs. 5 million (at 10% p.a.) and pays back the equity capital to those five owners leaving the firm. Thus, half of the equity is replaced with the bank loan.

 

Being a financial analyst, you are required to suggest that:

 

  1. 1.     What impact does this situation have on Return on Equity (ROE) of the firm and Total Return to its Investors?
  2. 2.     Is it beneficial to add more and more debt to the firm’s capital structure? Support your answer with logic

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DEFINITION OF 'RETURN ON EQUITY - ROE'

The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.

Also known as "return on net worth" (RONW)

There are several variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the following: return on common equity (ROCE) = net income - preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income byaverage shareholders' equity. Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the shareholders' equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

Things to Remember
  • If new shares are issued then use the weighted average of the number of shares throughout the year.
  • For high growth companies you should expect a higher ROE.
  • Averaging ROE over the past 5 to 10 years can give you a better idea of the historical growth.

DEFINITION OF 'RETURN ON INVESTMENT - ROI'

A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

The return on investment formula:

 

Return On Investment (ROI)

In the above formula "gains from investment", refers to the proceeds obtained from selling the investment of interest. Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.

Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing the gross profit that each product has generated by its respective marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit the user's purposes, and the result can be expressed in many different ways. When using this metric, make sure you understand what inputs are being used.

TOTAL RETURN
When measuring performance, the actual rate of return of an investment or a pool of investments over a given evaluation period. Total return includes interest, capital gains, dividends and distributions realized over a given period of time.

TOTAL RETURN
Total return accounts for two categories of return: income and capital appreciation.

Income includes interest paid by fixed-income investments, distributions or dividends.

Capital appreciation represents the change in the market price of an asset.

If Business is 100%Equity then  No Debt and No Interest.

PLEASE SHARE IDEAS

To understand the solution of GDB please read the below statement


Financial Risk (Investor’s Point of View):
Suppose firm ABC had a Capital Structure of 100% Common Equity. Then the
Management and Board of Directors of firm ABC then decide to reduce half of the equity and take a loan (or Debt) instead. This affects the distribution of risk & return to the common equity holders (or Owners). In other words, the Management of firm ABC has added a new kind of investor. The debt holder faces almost no risk because he is “guaranteed” the Interest payment at all costs whether or not the firm is making profit or whether or not the equity owners are paid dividend. Debt holders eat away at the owners’ (or equity holders’) money at almost no risk. So, naturally, the risk faced by equity holders increases because same Business Risk is now shouldered by fewer Equity Shares. Risk per Share Increases.

Generally Speaking,
Increasing Debt Shifts More Risk Upon the Shareholders. Therefore required ROR demanded
by the Common Equity Holder also increases (based on CAPM Theory).
Firm’s Total Stand Alone Risk (Uncertainty in ROA & ROE):
Firm’s Total Stand Alone Risk measured by the Uncertainty or Fluctuations in Possible outcomes for Firm’s Future overall ROR.


If Business has Debt & Equity (i.e. levered firm):
Firm’s Overall ROR = ROA = Return on Assets = Return to Investors / Assets = (Net
Income+ Interest) / Total Assets
Note: Total Assets = Total Liabilities = Debt + Equity


If Business is 100%Equity (or un-levered firm)
No Debt and No Interest.


Firm’s Overall ROR = Net Income / Total Assets. For 100% Equity Firm, Total Assets =
Equity. So Overall ROR= Net Income / Equity= ROE!
Note: Net Income is also called Earnings.
Note: ROE does not equal rE (Required Rate of Return). ROE is Expected book return on Equity.

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