Question

As we know,if the NPV is positive ,we need to take on this investment opportunity.now we expect the return on equity will increase by 5% in next five years.what would be an appropriate financial strategy for the distribution of company’s earning?assume that today is 2016 June 13, the stock price is 38.3,the net income is 230.8,cash flow is -22,DPS is 1.39,DPR is 60.8399,dividend yield 3.577,dividend paid-138.3.

Answer 1

Return on equity is a must-know financial ratio. It explains, mathematically, the ratio of a company's net income relative to its shareholder equity.

ROE = Net Income / Shareholder's Equity

So ROE can be increased by either increase in Net Income or by decrease in Shareholder's equity.

There are several ways in which ROE can be increased:-

- By using more Financial Leverage

By increasing the amount of debt capital relative to its equity capital, a company can increase its return on equity.

- Increase profit margins:-

As profits are in the numerator of the return on equity ratio, increasing profits relative to equity increases a company's return on equity. Increasing profits does not necessarily have to come from selling more product. It can also come from increasing prices of each product sold, lowering the cost of goods sold, reducing its overhead expenses, or a combination of each.

- Improve asset turn over:-

Asset turnover is a measure of a company's efficiency. You can calculate it by dividing sales by the company's total assets. In general, the more sales a company produces relative to its assets, the more profitable it should be, and the higher return on equity it should earn.

- Distribute Idle Cah:-

idle cash in excess of what the business needs to continue operations reduces the apparent profitability of the company when measured by return on equity.  Distributing idle cash to shareholders is effectively a way to leverage a company, and boost its return on equity.

- Lower Taxes:-

Lowering the taxes will increase the profit margins and ultimately our ROE.

From the question it seems like company a paying a major part of its earnings to its shareholder as Dividend payout ratio is 60% & we can also see that cash flow which i assumed to be total cash flow is negative i.e. cash flow from all the activities sum's to negative.

So in my opinion company can do below :-

Company should reduce their Dividend Payout Ratio to a certain level so that they do not have to face a negative cash flow. We do not want the DPR to be 0 as this will lead to increased Equity and less ROE.

Also they can take debt for fullfilling its negative cash requirement which will increase its Financial Leverage and also inproves company's ROE (That what we expect), but taking debt is not good for the health of a company.

Thank You!!