BUS 401: Principals of Finance

BUS 401: Principals of Finance
Week Three Instructor Guidance
This week, we will focus on these following areas:
1. Formulate the expected financial returns of a company.
2. Assess potential financial risks of a company.
3. Calculate a company’s Return on Equity and Constant Growth Stock Valuation.
4. Evaluate the types of capital constraints a company must consider in order to be
competitive in their market.
5. Interpret financial data to explain whether or not a company is making appropriate capital
expenditure allocations.
Formulate the expected financial returns and associated risks by completing the following
calculations.
Calculate the Return on Equity (ROE) using the DuPont system.
According to Joe Lan’s, CFA article on “Breaking Down ROE Using the DuPont Formula” ,
although return on equity is a useful tool, it does not tell you what factors are helping or hurting
the company’s performance. The DuPont formula addresses this concern by breaking down ROE
and allowing investors to see which characteristics are driving ROE. Analysis of the DuPont
formula allows you to determine whether management is generating value for shareholders
effectively.
The DuPont formula breaks down ROE into three distinct elements—profitability, efficiency and
financial leverage. The formula is used by investors to compare and analyze the source of a
company’s ROE compared to historical trends or other companies in similar industries. The
DuPont formula breaks down ROE as follows:
ROE = net profit margin × asset turnover × equity multiplier
Alternatively, the DuPont formula can be written as follows:
ROE = (net profit ÷ sales) × (sales ÷ assets) × (assets ÷ equity)
The DuPont formula allows you to ascertain if a company has been able to effectively use debt
to drive stronger profits as well as how margins and asset turnover are trending over time. Be
sure to compare ROE and its drivers to other companies in the same industry rather than against
all companies. Any outliers should be closely examined. An abnormally high margin or turnover
is hard to maintain, while an unusually low margin or turnover may signal financial difficulties
ahead. In addition to, your analysis should include a three years comparison of the return
on equity and industry average, highlighting the trends and possible reasons for the
changes in the trends.
BUS 401: Principals of Finance
Lan,Joe. (December 2012). Breaking Down ROE Using the DuPont Formula. Retrieved from
http://www.aaii.com/journal/article/breaking-down-roe-using-the-dupont-formula.touch (Links
to an external site.)Links to an external site.
Calculate the Constant Growth Stock Valuation (CGSV) and compare it to the current
stock price.
Constant Growth Stock Valuation
A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the
foreseeable future. This condition fits many established firms, which tend to grow over the long
run at the same rate as the economy, fairly well. The value of a constant growth stock can be
determined using the following equation:
where
P0 = the stock price at time 0,
D0 = the current dividend,
D1 = the next dividend (i.e., at time 1),
g = the growth rate in dividends, and
r = the required return on the stock, and
g < r.
In addition, the present value of a stock with constant growth is based on the dividend discount
model, which sums the discount of each cash flow to its present value. The formula shown above
for stocks with constant growth uses the present value of a growing perpetuity formula, based on
the underlying theoretical assumption that a stock will continue indefinitely, or in perpetuity.
This assumption is not without scrutiny, however the present value of a growing perpetuity can
be used as a comparable measure along with other stock valuation methods for companies that
are stable and tend to have a calculable outcome of steady growth.
Do = $1.82
Re = 16%
G = 10%
$1.82 (1.10)/ 0.16 – 0.10 = $2.00/0.06 = $33.33= Po or expected stock price
BUS 401: Principals of Finance
If your chosen company does not payout a dividend use the following input:
Do = Use the Earnings per-share of your chosen company (Note if a firm could payout all of its
earnings to the shareholders is would equal the firm’s earnings per-share)
Re = Chosen company return on equity [Use the Capital Assets Pricing Model or the Re =
EPS/stock price + expected growth rate of EPS]
EPS = $1.43
Po or stock price = $18.82 current stock price
G= growth rate of the EPS = 6.6% (Compute the percentage change between current EPS and
the last EPS)
$1.43/$18.82 +6.6% = 7.6% +6.6% =14.2%
Constant Growth Dividend Model:
$1.43 (1.066)/ 14.2 – 6.6% = $20.06 compare this price this value to the chosen company current
stock price and competitors.
Evaluate the types of capital constraints a company must consider in order to be
competitive in their market.
There are three ratios to examines or assess the financial strength of a company capital position.
The debt and debt/equity ratio, are popular measurements; however, it’s the capitalization ratio
that delivers the key insights to evaluating a company’s capital position. The capitalization ratio
(total debt/total capitalization) compares the debt component of a company’s capital structure
(the sum of obligations categorized as debt + total shareholders’ equity) to the equity component.
Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is
always more desirable than a high percentage of debt. A company’s reasonable, proportional use
of debt and equity to support its assets is a key indicator of balance sheet strength. A healthy
capital structure that reflects a low level of debt and a corresponding high level of equity is a
very positive sign of investment quality.
You should review all of your written assignments feedback and incorporate the necessary
changes for each of the past week assignments.
Week Three Recommended Resources:
Week three recommended assignment website resources:
Constant Growth Stock Valuation. Retrieved from
http://www.zenwealth.com/BusinessFinanceOnline/SV/CGStock.html
BUS 401: Principals of Finance
Present Value of Stock – Constant Growth. Retrieved from http://www.financeformulas.net/PresentValue-of-Stock-with-Constant-Growth.html
Constant Growth
Constant Growth Formula for valuation of common stocks. This http://www.Tutor4finance.com
Second Video – Constant Growth-Tim Liptrap- Published on Jan 11, 2014. Principles of Finance class.
The Constant Growth Model finding the most you would be willing to pay for a stock.

DuPont equation tutorial. ROE: Return On Equity. ROA: Return On Assets. ROS: Return On Sales.
This video takes you through the financial ratios of the ROE formula
…https://video.search.yahoo.com/yhs/search?fr=yhs-trp-001&hsimp=yhs001&hspart=trp&p=videos+Calculate+the+Return+on+Equity+%28ROE%29+using+the+DuPont+sys
tem.#id=3&vid=ad97163abba026e3985bd4504595c475&action=click (Links to an external site.)Links
to an external site.
Ingram, David. (n.d.) Qualitative Factors in Capital Investment Decisions. Retrieved from
http://smallbusiness.chron.com/qualitative-factors-capital-investment-decisions-73769.html (Links to
an external site.)