Currently, APP seems to have no business risk but may face a certain risk In the long UN. Based on the ratios shown on the attached sheet, APP should not worry about business risk since Its working capital Is very healthy ($1472. 8 million) and cash excess $233 million. The high ROAR, high profit margin, low current-to-asset ratio and 49. 71 collection days show that APP can generate cash quickly, thus It can malting current high growth rate. However, it’s decreasing annual sales growth from 14. 1 % in 1978 to 8. % in 1981 (exhibit 1) shows that it faces future risk of losing market shares n all its business lines if it does not foresee competition and continues to focus on increasing stockholders’ value. Pap’s current financial performance is very good since it has high ROE (30. 3), high quick ratio (42. 68), low debt-to-equity ratio (0. 09) and low debt-Waste ratio (0. 01 However, an analysis of different debt ratios shows that if APP increases debt ratio, it will face a financial risk of increased debt-to-equity and debt-etc;-asset ratios.
In other words, it will face solvency problems in long terms. APP also face liquidity problems nice the quick ratios decrease when the debt ratios increase. 2 The proposed mechanism follows a dual mechanism of leveraging:- (a) Increase the Debt Equity Ratio. (b) Buy back the shares. This also results In the following:- (l) Improves PEPS as the amount gets shared by lesser number of shares. (II) Improves Price / earnings ratio (Ill) The excess capital gets utilized. (lb)Sends a +eve signal to the market and share prices likely to Increase. (v) Improves Return on Equity ratio.
The calculations enclosed Indicate that the best option In accordance with the many stated policy would be to have Debt-Equity Ratio of 70%. Shareholders’ value increases when debt ratios increase. PEPS increases from $3. 18 to $3. 49. The dividend payout ratio also increases from 0. 597 to 0. 602. Similarly, the dividend yield from 0. 063 to 0. 070. It means that the company can increase shareholders’ value by However the following needs to be considered:- (I) The valued net worth of the firm which decreases may not convey the correct picture to the investor and thus negating the positive signals of buy back of shares. T) The firm has no strategy related to R in new products and focuses on me-too products thus constituting a large business risk. (iii) The firm would reduce the cash to debt ratio substantially exposing itself to financial risk. The closest competitor has Debt – Equity Ratio of 30% which if taken as a benchmark gives a conservative method of deciding the proposed leveraging, however this does not maximize the shareholder value, but is in line with the strong conservatism philosophy of the firm. It also gives a better Return on Assets ratio and has a safer Debt to Cash ratio.
Even though APP has a very good current financial performance, it should change the financial policy to increase debt ratio at a certain level. To meet the goal of increasing shareholders’ value, APP should not use its excess cash flow to repurchase its stocks because this is only a temporary solution and may generate serious financial problems in the long run. Instead, APP should use this excess cash to invest in profitable projects to improve its current products and launch new products that meet current market demands.
By doing so, APP can minimize the business risk, repaper itself for competition and increase sales growth. On the other hands, APP should increase debt ratio to a certain level that is suitable for its business to increase shareholders’ value. Also it should continue to exercise tight monetary policies as earlier to pay off the debt in a disciplined manner This solution does not bring financial risk to APP but enable it to minimize business risk. If APP remains only concerned about how to increase shareholders’ value and ignores market threats, it might lose its business to its competitors.
