Which firm\'s shareholders are wealthier? Explain why. The following are selecte

Question

Which firm's shareholders are wealthier? Explain why.The following are selected financial information on Firm A and Firm B. You are asked to complete the table by methodically calculating the missing information.

You will assume that Cost of Goods Sold (COGS) is 65% of Sales and that the company uses a marginal tax rate of 35%.

                                                Firm A             Firm B

Revenue                     $               3,000         $ 3,000

COGS                                       (Blank)           (Blank)

Gross Profit                            1,050              1,050

Operating Expenses             (300)             (300)

EBIT                                        750                 750

Interest Expense                   (Blank)           (Blank)

EBT                                         (Blank)           (Blank)

Income Tax @35%               (Blank)           (Blank)

Net Income                            $488               $472

Earnings per share               (Blank)           (Blank)

Dividends per share             (Blank)           (Blank)

Expected Return on Equity (Blank)           (Blank)

Estimated Share Price          (Blank)           (Blank)

Market Value of Equity        (Blank)           (Blank)

Market Value of Debt           (Blank)           (Blank)

Enterprise Value                   $2,181                        $2,503

Outstanding Debt                 $     -                $300

Shares Outstanding              600                 300

Cost of Debt                           6%                  8%

Beta                                        1.40                1.70

Expected return on Market 9%                  9%

Dividend pay-out ratio         50%                60%

Dividend growth                   2%                  2%

Risk free                                 3%                  3%

Common equity                     $600               $300

Company’s debt trading @ n/a                  105

Which firm's shareholders are wealthier? Explain why.

Explanation / Answer

For Firm A, Earning per share = Profit after tax (Net income) / No of outstanding shares

For Firm A, Earning per share = 488/600 = $.8133

For Firm B, Earning per share = Profit after tax (Net income) / No of outstanding shares

For Firm B, Earning per share = 472/300 = $1.5733

Since, earning per share is more in case of firm B than Firm A so shareholders of Firm B are more wealthier.

Firm A Firm B Comments / formula Revenue 3000 3000 COGS 1950 1950 COGS = Revenue*65% Gross Profit 1050 1050 Operating Expenses 300 300 EBIT 750 750 Interest Expense 0 24 interest expense = debt amount * cost of debt EBT 750 726 Income tax @ 35% 262 254.1 = EBT*tax rate Net Income 488 472 Earning per share 0.813333 1.573333 EPS= Net income / No of outstanding shares Dividend Per Share 0.406667 0.944 DPS = EPS * Dividend payout ratio Expected Return on Equity 0.114 0.132 Expected Return on Equity of Firm A = Risk free return + Beta * (Market Return - Risk free return) Estimated Share Price 4.412766 8.597143 Share Price = D0*(1+ g)/(R - g)                                here, g = Dividend growth rate and R = expected equity return Market Value of Equity 2647.66 2579.143 Market value = Market Share price * No. of shares Market Value of Debt 0 3750 Debt value = Debt / Cost of Debt Enterprise Value 2181 2503 Outstanding Debt 0 300 Shares Outstanding   600 300 Cost of Debt   6% 8% Beta 1.4 1.7 Expected return on Market 9% 9% Dividend pay-out ratio   50% 60% Dividend growth 2% 2% Risk free 3% 3% Common equity   600 300 Company’s debt trading 0 105 Expected Return on Equity of Firm A = Risk free return + Beta * (Market Return - Risk free return) Expected Return on Equity of Firm A = 3% + 1.4*(9% - 3%) = 11.4% Similarly, Expected Return on Equity of Firm B = 13.2% Share Price = D0*(1+ g)/(R - g)    g = 2% R = 11.4% for firm A and 13.2% for Firm B

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