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 P/E
i) expected 5-year growth in earnings
ii) dividend payout ratio
iii) sales stability stable
iv) institutional stock ownership
v) financial leverage/use of debt

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.