An analyst has provided you with the following actual financial information developed from the reformulated financial statements of Revelstoke Inc. for the year 2020, and then a set of forecasted financial information for the two-year period, 2021 – 2022:
2020 Actual: Sales = $750,000
Financial leverage (FLEV) = 3.50
Net Financial Obligations (NFO) = $350,000
2021 E 2022 E
Sales growth 10% 5%
Operating Profit Margin (after tax) 0.05 0.05
Financial Leverage (FLEV) 3.25 3.00
Net Financial Obligations (NFO) $350,000 $350,000
In conjunction, you have also been provided with the following additional information:
the forecasted growth rate in comprehensive income after tax (CI) after 2022 is 2.5%
Revelstoke has 100,000 common shares outstanding
Revelstoke’s firm’s cost of equity capital is 8%
Revelstoke’s net borrowing cost (NBC) after tax is 4.5%
While you agree with the analyst’s forecasts of future sales growth and operating profit margins, you believe that rather than decreasing its financial leverage (FLEV), Revelstoke will change its capital structure in 2021 so that its financial leverage ratio (FLEV) increases to 4.0, and then remains constant at 4.0 from 2021 into the future. This increase will result in net financial obligations (NFO) increasing to $425,000 in 2021 and $450,000 in 2022. As a result, you believe that the appropriate cost of equity capital will be 9.0% and the net borrowing cost will be 5% after tax because the firm will be riskier, and that its terminal growth rate will be 3% because its CI will grow more rapidly because of the benefits of the increased financial leverage.
Given this info, You work for ABC Bank and are reviewing the financial statements for one of the bank’s customers under the terms of the line of credit facility. The credit facility requires the customer to maintain a debt-to-equity ratio of less than 1.0. During the year, the customer’s debt-to-equity ratio increased from 0.8 to 1.1, so you asked the customer to explain the reason for this change. Which of the following is the most plausible explanation for this result?
1. The company refinanced a mortgage that came due during the year
2. The company improved its cash collection practices
3. The company repurchased some of its own stock this year
4. The company generated record profits this year