Accounting Analysis And Equity Valuation

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Questions:

(i) Obtain a copy of IHC’s latest annual report (for the year ended 31 December 2015) either from the company or SGX website. Decompose IHC’s return-on-equity (ROE) using the alternative approach as described in the PHP textbook page 5-6 to page 5-8.

(ii) Using the decomposition of IHC’s ROE in part (i) together with the residual income model (also known as the discounted abnormal earnings model in PHP), explain how IHC’s high financial leverage position is destroying shareholder value.

Answers:

Introduction

In this report, an attempt is made to discuss the fall in share price of the International Heathway Corporation by 85% since its listing in SGX.  In order to do that return on equity of the company is decomposed using an alternative method of ROE DuPont decomposition. This report aims to discuss the negative impact that the high financial leverage has on the value of the shareholder. The report also discuss the impact that the activist investor has on the value of the shareholder of the company.

Company Background

The International HealthWay Corporation limited is engaged in the business of healthcare facility and services. The company has come a long way since its inception on 2010. The company is focused in delivering high quality health care service. 

Application Of Advanced DuPont ROE Decomposition

The Return on Equity is an important indicator of profitability that indicates the ability of the firm to generate income from the funds invested by the shareholders (Khachatryan et al., 2015). The traditional approach of measuring return on equity is:

ROE= Net profit/ Equity

The Traditional method of measuring ROE is popular but it has certain limitations. In traditional approach, the ROE can be decomposed into return on assets and financial leverage. The traditional approach suffers from various limitations so an alternative approach is used for decomposing the ROE.

The DuPont analysis is a model that is based on the return on equity ratio. It is useful in measuring the ability of the company to increase the return on equity (Chatrchyan et al., 2015). This model decomposes the return on equity ratio into three main components:

  • Return on business assets;
  • Spread; and
  • Financial leverage;

Based on the analysis of this performance measures it can be said that the company can increase the return on equity by increasing its return from business assets and spread. The business can also increase in the ROE by using the leverage effectively.

In this section of the report, the ROE of the International health way Corporation is decomposed using the DuPont analysis model. The formula used for calculating the DuPont analysis is:

Return on Equity= NOPAT/Net Assets X (1+Net debt/Equity) – (Net Interest expenses after tax/Net Debt) X (Net debt/Equity)

The calculation of Return on equity is shown below:

Decomposing ROE using DuPont Analysis
Particulars20152014
 in thousandin thousand
Net Profit SGD           466.00 SGD     31,356.00
Add:  
Interest Expenses SGD     26,947.00 SGD     22,259.00
NOPAT (A) SGD     27,413.00 SGD     53,615.00
Equity (B) SGD   192,707.00 SGD   185,219.00
Net Assets (C ) SGD   207,263.00 SGD   198,374.00
Net Debt (D) SGD   139,720.00 SGD   169,942.00
Interest expenses after tax (E) SGD        2,236.60 SGD        1,847.50
Return on Equity (A/C)X(1+(D/B)-(E/D)*(D/B)22%51%

 Table 1: Decomposing ROE

(Source: Created by Author)

Note: Tax rate is 17% for 2014

The above table shows the calculation of return on equity and the effect that different performance measures has on the ratio. It can be seen that the ROE was  51% in the year 2014 and it drastically fell and became 22% in 2015. The DuPont analysis helps to identify the reason for the decrease in the ROE. On analysis, it can be seen that the interest after tax has increased in 2015 than 2014 (Khachatryan et al., 2015). The primary reason for decline in ROE is the decrease in Net Operating profit after tax of the company in 2015. Therefore, by applying the DuPont analysis the problem area that has caused decline in ROE is identified as decline in net operating profit margin. Based on the above discussion it can be said that the company can increase its ROE by increasing the opearting profit.

Excessive Use Of Financial Leverage Destroying Shareholders Value

The goal of a business is to maximize the wealth for the shareholder. The ROE is an important measure that indicates the return that a shareholder can obtain from investment. The impact of increased or decreased financial leverage can be positive or negative depending on the increase in the level of the risk (Ioannou&Serafeim, 2016). It can be said that if the financial leverage is in an acceptable level then the ROE of the company will increase. However if the company is financially overleveraged then the increase in debt will further reduce the shareholders wealth (Masulis et al., 2016).

In this case, the role of high financial leverage in destroying the shareholder value of International health way corporation can be explained with theabnormal earning model. The method of determining theworth of the business using the earnings and book value of shares is known asabnormal earning valuation model (Admati et al., 2013). This model analyses whether a decision of the management positively or negatively influence the performance of the company.  This model states that if the earnings of the company are higher than the expected return then the investors should pay more than the book value. On the other hand, if the earning is less than the expected earning then the investor should pay less than the book value. In this case, it has been seen that the financial leverage of the company has increased from 2014 to 2015. This increase in debt has resulted in increase in the interest cost thatin turn has resulted in decline in the profit margin and return on equity (Gormley&Matsa, 2016). Based on the abnormal earning model it can be said that as the profit and return on equity has declined as a result the value to the shareholder have also declined. In short, it can be said that the increase in debt has destroyed the value to the shareholder (Goranova et al., 2017). The calculation showing valuation using the abnormal earning method is given below:

Valuation Using Abnormal earning
YearBook ValueEarningCapital ChargeAbnormal EarningPV FactorPV of abnormal earning
0 SGD                     192,707.00 SGD         466.00    
1 SGD                     154,165.60 SGD   69,004.52 SGD      15,416.56 SGD           53,587.96 SGD   0.91 SGD                       48,716.82
2 SGD                     123,332.48 SGD   75,904.97 SGD      12,333.25 SGD           63,571.73 SGD   0.83 SGD                       52,535.68
3 SGD                       98,665.98 SGD   83,495.47 SGD        9,866.60 SGD           73,628.87 SGD   0.75 SGD                       55,317.37
Cumulative PV of abnormal earning     SGD                    156,569.86
Beginning book value     SGD                    192,707.00
Equity Value     SGD                    349,276.86

Table 2: Valuation using abnormal earning

(Source: created by author)

Assumed: Profit Margin as average 44.76%
Assumed: the equity charge is assumed to be 25%
Assumed: Book value of share will decline by 10%
Assumed: Earning will increase by 10%

Impact That The Activist Investor Has On The Shareholder Value Of A Company

The shareholders own the company and they have the right for one vote per share. It can be seen that the most investor does not seek to get involved in the management decision. However, there are certain investors that uses their voting rights to influence the management decision. The investors that pushes the management to change the manner in which the company is operated is known as the activist investor. The activist investor include mutual funds, pension funds and hedge funds (McCahery et al., 2016).

The activist investors are interested in various aspect of the business.There are certain activist investors that are interested in the daily operation of the business. In most cases, the activist investors are mostly interested in the onetimerestructuring of the business. The activist investor sometimes pushes management to acquire company and sometime for selling the company. The activist investor has become very popular after 2008 crisis. These activist investors are looking for purchasing a large number of shares at lower price and selling the shares at higher price after reengineering the company (Goranova& Ryan, 2014).

https://getperfectessays.com/financial-and-management-accounting/

The activist investors are criticized as beingfocused on the short-termgoals of the company. The activist investors are interested in return so the cash that the company pay out as dividend can result in lesser investment in the research and development. This development could influence the future growth of the company. There was a study conducted on the 2000 companies that was targeted by the activist investors (Norli et al., 2015). The study concluded that the activism has a positive impact on the value of the shareholder for both the shorter and longer period. The economist from Harvard Lucian Bebchuk is of the view that the investor activism has helped the company to improve their performance consistently as compared to their peers. On the other hand, a recent study conducted has found that investor activism has little impact on growth and the profit margins (Bebchuk et al., 2015).The focus of the activist investor is to increase the shareholders’ value as a result they sometimes ignore the impact that the company has on environment or employees. Therefore, based on the above discussion it can be said that the activist acts as a tough disciplinary for managers and pushes them for increasing the value of the shareholder. The conclusion that can be drawn from the above discussion is that the activist investor has helped in increasing the value of the activist investor.

Conclusion

This report has decomposed the return on equity to conclude that the fall in ROE is due to fall in profit margin. The report further helps to draw conclusion that the increase in debt increases profit up to the level where optimum capital structure is reached. Then after reaching the optimum capital structure if the debt is increased then the profit will decline and the shareholders’ value will decline. The second portion of the report discusses the impact that the activist investor has on the shareholders’ value. It can be concluded that the focus of the activist investor is to increase the value of the shareholders.

Reference

Admati, A. R., DeMarzo, P. M., Hellwig, M. F., &Pfleiderer, P. C. (2013). The leverage ratchet effect.

Bebchuk, L. A., Brav, A., & Jiang, W. (2015). The long-term effects of hedge fund activism (No. w21227). National Bureau of Economic Research.

Chatrchyan, S., Khachatryan, V., Sirunyan, A. M., Tumasyan, A., Adam, W., Bergauer, T., …&Frühwirth, R. (2014). Search for the standard model Higgs boson produced in association with a W or a Z boson and decaying to bottom quarks. Physical Review D, 89(1), 012003.

Goranova, M., & Ryan, L. V. (2014). Shareholder activism a multidisciplinary review. Journal of Management, 40(5), 1230-1268.

Goranova, M., Priem, R. L., Ndofor, H. A., &Trahms, C. A. (2017). Is There a ‘Dark Side’to Monitoring? Board and Shareholder Monitoring Effects on M&A Performance Extremeness. Strategic Management Journal.

Gormley, T. A., &Matsa, D. A. (2016). Playing it safe? Managerial preferences, risk, and agency conflicts. Journal of Financial Economics, 122(3), 431-455.

Ioannou, I., &Serafeim, G. (2016). The consequences of mandatory corporate sustainability reporting: evidence from four countries.

Khachatryan, V., Sirunyan, A. M., Tumasyan, A., Adam, W., Bergauer, T., Dragicevic, M., …&Hartl, C. (2015). Precise determination of the mass of the Higgs boson and tests of compatibility of its couplings with the standard model predictions using proton collisions at 7 and 8, text {TeV}. The European Physical Journal C, 75(5), 212.

Khachatryan, V., Sirunyan, A. M., Tumasyan, A., Adam, W., Bergauer, T., Dragicevic, M., …&Ghete, V. M. (2015). Search for physics beyond the standard model in dilepton mass spectra in proton-proton collisions at s= 8TeV. Journal of high energy physics, 2015(4), 1-49.

Masulis, R. W., Wang, C., &Xie, F. (2016). Employee-Manager Alliances and Shareholder Returns from Acquisitions.

McCahery, J. A., Sautner, Z., & Starks, L. T. (2016). Behind the scenes: The corporate governance preferences of institutional investors. The Journal of Finance.

Norli, Ø.,Ostergaard, C., &Schindele, I. (2015). Liquidity and shareholder activism. Review of Financial Studies, 28(2), 486-520.

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