3. Coping with Excess Cash

3.8. Step 6: Implications for Accounting Performance

To conclude the discussion, let us briefly investigate how the levered recapitalization affects the accounting profitability of the firm. In particular, we want to know how return on equity (ROE) and earnings per share (EPS) change:

  • From the introductory page, remember that the firm generates an EBIT of 82.7143 billion.
  • Current financing policy: Under the current financing policy (150 billion of excess cash), interest income is 3 billion so that taxable income is 85.71 billion. Given a tax rate of 30%, taxes amount to 25.71 billion and net income is 60 billion.
     
  • Post recapitalization: The proposed recapitalization leaves EBIT unaffected. However, with net debt of 100 billion, the firm has annual interest expenses of 2 billion, which lowers taxable income to 80.71 billion. As a result, the firm's annual tax bill drops by 1.5 billion to 24.21 billion and net income is 56.5 billion.

 

The following table summarizes the firm's income statement before and after the proposed recapitalization:

 

  Current Post Recapitalization
EBIT 82.71 82.71
- Interest expenses -3.00 2.00
EBT 85.71 80.71
- Taxes 25.71 24.21
Net Income 60.00 56.50

 

Let us now analyze how EPS and (market value based) ROE are affected by the proposed transaction. The following table summarizes the analysis. In addition to the current situation and the actual proposed recapitalization, it also shows the resulting accounting profitability measures under the two additional payout policies considered before, namely an open market buyback program as well as a dividend payment: 

   

Current Post recapitalization
Proposed Transaction Open Market Buyback Dividend Payment
Net income 60.00 56.50 56.50 56.50
Market value of equity 600 425 425 425
Number of shares outstanding 6.00 4.00 3.78 6.00
EPS (Net income / Number of shares) 10.00 14.13 14.96 9.42
ROE (Net income / Market value of equity) 10.00% 13.29% 13.29% 13.29%

   

Discussion

  • Under the current capital structure, the firm's earnings per share (EPS) are 10 and return on (market) equity (ROE) is 10%. 
     
  • With the proposed transaction, both EPS and ROE increase. Specifically, EPS increases to 14.13 (= 56.5/4) and ROE increases to 13.3% (=56.5/425).
     
  • However, we have to be careful when interpreting these performance measures. Let's discuss (again) why.
     
  • ROE:
    • As we have argued before (in this module, and more extensively in the module Financial Analysis for Managers), ROE is a blended profitability measure of operating performance and financial leverage. 
       
    • Higher ROE does not necessarily mean that shareholders are better off. It could simply reflect the fact that the equity claim becomes riskier while shareholder value remains the same (or even declines). 
       
    • By looking at the ROE number, it is therefore impossible to disentangle the two effects (higher profitability or more risk). 
        
  • EPS:
    • The change in EPS is primarily driven by the number of shares that the firm repurchases. As we have already argued before, this repurchase decision is, in principle, value neutral. Specifically, with respect to the three potential forms of payout considered in the case of Pear, we have seen that they all have the same value implications for the shareholders: Total shareholder wealth increases by 75 billion and shareholders receive a cash consideration of 250 billion.
       
    • Yet when we look at EPS, the three forms of distribution have strikingly different effects: 
      • With the proposed transaction, EPS goes to 14.13
      • With an open market buyback program, EPS increases even further, namely to 14.96. The reason is that the repurchase price is lower (112.5 instead of 125), which allows the firm to repurchase a larger number of shares (2.22 billion instead of 2 billion).
      • In contrast, if the firm pays a dividend, EPS drops to 9.42. The reason is that, with a dividend, the number of shares outstanding remains the same.  
         
    • Therefore, EPS is an unreliable measure of shareholder value creation! There is no causal effect from EPS on shareholder value. In our case, shareholders should not care whether EPS increases to 14.96 (open market buyback) or drops to 9.42 (dividend). In both cases, they stand to earn 75 billion!
       
    • Since this is such an important conclusion, the following page uses a stylized example to show that it is easy to fabricate transactions that destroy shareholder value while improving EPS. Management decisions should therefore NOT be based on EPS.