Question

You are analyzing two companies that operate in the same industry. They are both growing capital-intensive manufacturing companies, Guerr Corp. and Filk Corp. A diligent reading of their annual reports reveals the following:

	Depreciation Method	Average Depreciable Life	Leases
Guerr Corp.	Straight line	Machinery: 10 years	Significant operating leases for machines extending up to 20 years in length
Filk Corp.	Double declining balance	Machinery: 20 years	All leases are capital leases

You know that these accounting differences will affect the comparability of the two company’s financial results. Consider each of the above items (depreciation method, average depreciable lives, and leases) separately and determine all other things being equal, whether the following ratios will be higher or lower for Guerr when compared to Filk. Explain your answers.

i. Observed P/E ratio

ii. Price to Free Cash Flow

iii. Price to Book Value

Answer 1

Assumptions:

• Revenue/costs other than depriciation and lease expenses are equal
• Both companies have two machines both costs $100,000.
  • Guerr - One machines comes at an annual operating lease of ​ $11,745.96​
  • Filk - One machine comes at a capital lease with 10% interest and annual payment of $11,745.96​ (calculated via =pmt(10%, 20, -$100,000) in excel)
• ​Gross profit - post other cost is $50,000 per year for both the companies
• Price per share is $10
• Number of shares outstanding is 100,000
• Tax rate is 30%
• There are no other assets apart from the machines

Calculations: Guerr Corp.

Calculations: Filk Corp.

Note:

• In case of capital lease, only the interest component of the lease will come in the income statement, pricipal will go directly in the balance sheet as capital payments.
• Free Cash Flows = Net Profit + Depriciation - Net capital Outlay

Answer i)

Price to Earnings ratio (P/E Ratio) = Price per share / Earning per share

Since everything else is equal apart from a few accounting policies regarding depriciation and lease expenses, following will be the difference:

Guerr Corp. $1/$0.20 = 5.06

Filk Corp. $1/$0.14 = 7.14

Answer ii)

Guerr Corp.:

Free Cash flow per share = Free cash flows / Total outstanding shares

= $29777.82/100,000

= $0.298

Price to Free Cash Flows = $1/$0.298

= 3.36

Filk Corp.

Free Cash flow per share   = Free cash flows / Total outstanding shares

= $32254.04/100,000

= $0.322

Price to Free Cash Flows = $1/$0.322

= 3.10

Free Cash flow per share   = Free cash flows / Total outstanding shares

= $29777.82/100,000

= $0.298

Price to Free Cash Flows = $1/$0.298

= 3.36

Answer iii)

Guerr Corp.:

Price to Book Value / share = Price per share / Book value per share

Book Value / share = Closing value of machine / Number of Outstanding shares

Book Value / share = $90000 / 100,000 i.e. $0.90

Price to Book Value / share = $1/0.90

Price to Book Value / share = 1.11

Filk Corp:

Price to Book Value / share = Price per share / Book value per share

Book Value / share = Closing value of machine / Number of Outstanding shares

Book Value / share = $90000+$90,000 / 100,000 i.e. $1.80 (In capital lease machine is held by the lessee)

Price to Book Value / share = $1/1.80

Price to Book Value / share = 0.56