Tutorial 9 Solutions – Security Analysis – II

[Readings: Ch10; Ch13 & Ch15]

Q1 [Ch10 – Q7] When examining a firm’s financial structure, would you be

concerned with the firm’s business risk? Why or why not?

When examining a firm’s financial structure, we would also be concerned with its
business risk. Since financial risk is the additional uncertainty of returns faced by equity
holders because the firm uses fixed-obligation debt securities, the acceptable level of
financial risk usually depends on the firm’s business risk. For a firm with low business
risks, investors are willing to accept higher financial risk. On the other hand, if the firm
has very high business risk, investors probably would not feel comfortable with high
financial risk also.

Q2 [Ch10 – Q9] Why is the analysis of growth potential important to the common
stockholder? Why is it important to the debt investor?

Growth analysis is important to common stockholders because the future value of the
firm is heavily dependent on future growth in earnings and dividends. The present value
of a firm with a growing dividends payment is:

Dividend Next Period

V
Required Rate of Return - Growth Rate

Therefore, an estimation of expected growth of earnings and dividends on the basis of the
variables that influence growth is obviously crucial. Growth analysis is also important to
debt investors because the major determinant of the firm’s ability to pay an obligation is
the firm’s future success which, in turn, is influenced by its growth.

Q3 [Ch10 – Q10] Discuss the general factors that determine the rate of growth of
any economic unit.

The rate of growth of any economic unit depends on the amount of resources retained
and reinvested in the entity and the rate of return earned on the resources retained. The
more reinvested, the greater the potential for growth. In general:

Growth = Retention Rate x Return on Equity

= (1- dividend payout ratio) x Net Income/Sales x Sales/Total Assets x Total Assets/Equity

The dividend payout ratio is the proportion of earnings distributed to shareholders as

dividends so the complement of this ratio is the proportion of earnings retained. The
profit margin (Net Income/Sales) shows the firm’s ability to generate profits and to
control costs. The total asset turnover (Sales/Total Assets) is a measure of operating
efficiency. The equity multiplier (Total Assets/Equity) indicates the firm’s use of financial
leverage.

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Q4 [Ch10 – Q11] A firm has 24% ROE and has low business and financial risk.
Discuss why you would expect it to have a high or low retention rate.

Assuming the risk of the firm is not abnormally high, a 24% ROE is quite high and
probably exceeds the return that the equity investor could earn on the funds. Therefore,
the firm should retain their earnings and invest them at this rate.

Alternatively, if this firm has excess cash and expects to continue generating excess cash
it may decide to initiate or increase a cash dividend.

Q5 [Ch10 – P1] The Shamrock Vegetable Company has the following results.

Net sales $6,000,000

Net total assets 4,000,000

Depreciation 160,000
Net income 400,000
Long-term debt 2,000,000
Equity 1,160,000
Dividends 160,000

a. Compute Shamrock’s ROE directly. Confirm this using the three components.
b. Using the ROE computed in Part a, what is the expected sustainable growth
rate for Shamrock?
c. Assuming the firm’s net profit margin went to 0.04, what would happen to
Shamrock’s ROE?
d. Using the ROE in Part c, what is the expected sustainable growth rate? What
if dividends were only $40,000?

(a).
Net Income 400,000
Return on Total Equity    34.5% or using the 3 components :
Equity 1,160,000

Net Income Sales Total Assets

ROE  x x
Sales Total Assets Equity
400,000 6,000,000 4,000,000
 x x  34.5%
6,000,000 4,000,000 1,160,000
 0.067 x 1.5 x .3.448
 34.65% (slight difference is due to rounding)

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 (b) Growth Rate = (retention rate) x (return on equity)

= [1 – (160,000/400,000)] x .345

= (1 - .40) x .345

= .60 x .345

= 20.7%

(c) 0.04 x $6,000,000 = $240,000 (profit margin x sales)

240,000
ROE   20.7%
1,160,000
ROE  0.04 x 1.5 x 3.45  20.7%

(d) Using the ROE of 20.7 in part c) and a net income of $240,000, we have

Growth Rate = .60 x .207 = 12.42%

If dividends were $40,000, then RR = 1 – ($40,000/240,000)

= 1 - .167 = .833

Then growth rate = .833 x .207 = 17.25%

Q6 [Ch10 – P2]

Three companies have the following results during the recent period.

K L M
Net profit margin 0.04 0.06 0.10
Total assets 2.20 2.00 1.40
turnover
Total assets/equity 2.40 2.20 1.50

a) Derive for each its return on equity based on the three DuPont components.

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 b) Given the following earnings and dividends, compute the estimated
sustainable growth rate for each firm.

K L M
Earnings/share 2.75 3.00 4.50
Dividends/shar 1.25 1.00 1.00
e
(a) ROE = Net profit margin x Total asset turnover x Total assets/equity
Company K: ROE = 0.04 x 2.2 x 2.4 = .2112
Company L: ROE = 0.06 x 2.0 x 2.2 = .2640
Company M: ROE = 0.10 x 1.4 x 1.5 = .2100

(b) Growth Rate = Retention Rate x ROE = (1 - Payout Rate) x ROE

Company K: Growth Rate = 1 – (1.25/2.75) x .2112 = .545 x .2112 = .1151

Company L: Growth Rate = 1 – (1.00/3.00) x .2640 = .67 x .2640 = .1769

Company M: Growth Rate = 1 – (1.00/4.50) x .2100 = .778 x .21 = .1634

Q7 [Ch13 – Q8] Discuss at what stage in the industrial life cycle you would like to
discover an industry. Justify your decision.

As an investor, you would like to discover a firm just entering the rapid accelerating
growth stage. During this stage, a firm will experience high sales growth, high profit
margins, and little competition.

Q8 [Ch13 – Q12] List the three variables that are relevant when attempting to
determine whether the earnings multiple (P/E ratio) for an industry should be
higher, equal to, or lower than the market multiple.

Earnings multiplier (P/E) is determined by:

(1) the expected dividend payout ratio,

(2) the estimated required rate of return on the stock (k), and
(3) the expected growth rate of dividends for the stock (g).

Within the retail food industry, one would look at a company’s fundamental risk
(business, financial, liquidity, exchange and country risks). Differences in
fundamental risk levels will determine a company’s performance within the
industry. One could also look at the competitive environment of an industry –
rivalry among the existing competitors, threat of new entrants, threat of substitute
products, bargaining power of buyers, and bargaining power of suppliers.

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Q9 [Ch15 – Q1] Technical analysts believe that one can use past price changes to
predict future price changes. How do they justify this belief?

The principal contention of technicians is that stock prices move in trends that persist for
long periods of time. Because these trends persist they can be detected by analyzing past
prices.

Q10 [Ch15 – Q2] Technicians contend that stock prices move in trends that persist
for long periods of time. What do technicians believe happens in the real world to
cause these trends?

Technicians expect trends in stock price behavior because they believe that new
information that causes a change in the relationship between supply and demand does
not come to the market at one point in time - i.e., they contend that some investors get
the information before others. Also, they believe that investors react gradually over time
to new information. The result is a gradual adjustment of stock prices.

Q11 [Ch15 – Q9] Describe the Dow Theory and its three components. Which
component is most important? What is the reason for an intermediate reversal?

The Dow Theory contends that stock prices move in waves. Specifically, these waves may
be grouped into three categories based upon the period of the wave: (1) major trends for
long periods (tides); (2) intermediate trends (waves); and (3) short-run movements for
very short periods (ripples). The major trend (the tide) is most important to investors.
An intermediate reversal occurs when some investors decide to take profits.

Q12 [Ch15 – Q3] Explain the reasoning behind a support level and a resistance
level.

A support level is a price range where considerable demand is expected, while a

resistance level is a price range where a large supply is expected. Support and resistance
levels exist due to the behavior of a number of investors who are closely monitoring the
market and will trade quickly at attractive price levels. Specifically, a support level occurs
after a stock has increased in price followed by a brief period of profit-taking at which
time some investors who did not get in on the first round decide to take the opportunity
to get in. A resistance level occurs after a stock has declined and when it experiences a
recovery, some investors who missed selling at a price peak take the opportunity to sell.

A price break through a resistance level on strong volume would be considered very
bullish. This is because as the price rises to the target price set by investors, the supply
increases usually causing the price increase to reverse. Thus, a price breakthrough on
strong volume would be bullish because it would mean the excess supply is gone.

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Q13 [Ch15 – Q14] What is the purpose of computing a moving-average line for a
stock? Describe a bullish pattern using a 50-day moving-average line and the
stock volume of trading. Discuss why this pattern is considered bullish.

A moving average line indicates the major trend of a security’s price. When daily prices
break through the long-term trend from below on heavy volume it is considered a bullish
action. The move above the trend line may indicate a new upward change in the trend.

Q14 [Ch15 – Q17] Discuss why most technicians follow several technical rules and
attempt to derive a consensus.

Technicians recognize that there is no single technical trading rule that is correct all the
time - even the best ones miss certain turns or give false signals. Also, various indicators
provide different information for alternative segments of the market. Therefore, you
don't want to depend on any one technique, but look at several and derive a consensus.