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Payout policy (4 Mark) 7. Given that HD currently has an 80% dividend payout policy, you also show the interest income to lenders, and dividend income to shareholders, assuming both types of investors pay personal tax at 40% in each of the following tax environment: 1) the classic tax system; and 2) the imputation tax system. Explain which tax system is preferable theoretically. 1 2 Question 7 3 AFTER REPURCHASE 4 All figures in 000s Classic tax system Imputation tax system 5 Income Statement 6 EBIT 7 Less: Interest expense 8 Earnings Before Tax 9 Less: Taxes 10 Net Income 11 12 SHAREHOLDERS' ACCOUNT (at 80% payout ratio) 13 NI available for shareholders 14 Less: Taxes @ 40% 15 Plus: Franking credit 16 SH's ditributable funds 17 18 LENDER'S ACCOUNT 19 Interest earned 20 Less: personal taxes @ 40% 21 Lender's ditributable funds 22 23 DISTRIBUTABLE FUNDS 24 Shareholders after tax 25 Lenders after tax 26 Total distributed funds 4,662,282 6,897,624 27 28 29 Income Statement (000s) 30 Period Ending: 31/12/2019 31 Total Revenue 83,176,000 32 Cost of Revenue 54,222,000 33 Gross Profit 28,954,000 34 35 Operating Expenses 36 Sales, General and Admin. 21,884,200 37 Other Operating Items 2,146,300 38 Operating Income 13,609,700 39 Add'l income/expense items 438,100 40 EBIT 14,047,800 41 Interest Expense 1,079,000 42 Earnings Before Tax 12,968,800 43 Income Tax 4,720,300 44 Net Income-Cont. Operations 8,248,500 45 Net Income Applicable to 46 common shareholders 6,598,800 47 48 HD's business HD was a large producer of branded appliances primarily used in residential households. For the period 2015-2019 the industry posted modest annual unit sales growth of 1.8% despite positive market conditions including a strong housing market and product innovations. Competition from inexpensive imports and aggressive pricing by Mass Merchandisers Limited has reduced growth to 2.5% annually over the period. Under its CEO Benjamin White's leadership, HD operated much as it always had, with three notable exceptions. First, the company completed an IPO (Initial Public Offering) in 2014. This provided a measure of liquidity for founders' descendants who, collectively, owned 62% of the outstanding shares following the IPO. Second, beginning in the 2010s, HD has gradually moved its production abroad. Finally, HD had undertaken a strategy focused on rounding out and complementing its product offerings by acquiring small independent manufacturers and/or the kitchen appliance product lines of large diversified manufacturers. Thus far, all acquisitions had been for cash or HD stock. HD's historical performance During the year ended December 31, 2019, HD earned net income of $8.25 billion on revenue of $83.18 billion. Exhibits 1 and 2 present the company's recent financial statements. The company's 2019 EBIT margin of nearly 7.0% was average within the peer group. During 2015- 2019, compounded annual returns for HD shareholders (including dividends and stock price appreciation) was approximately 11.1% per year. This was higher than the ASX S&P200, which returned approximately 5% per year. However, it was well below the 16% annual compounded return earned by shareholders of HD's peer group during the same period. HD's financial policies HD's financial position was conservative and very much in keeping with HD's long- standing practice and, with its management style. In recent years the company's largest uses of cash Page 1 of 7 have been common dividends and cash consideration paid in various acquisitions. Dividends per share had risen only modestly during 2015-2019. However, as the company issued new shares in connection with some of its acquisitions, the number of shares outstanding increases to approximately 1.27 billion by the end of 2019. Net income (000s) Average number of shares outstanding (000s) Effective corporate tax rate Average cost of bonds 31/12/2019 8,248,500 1,267,881 36.50% (use this rate in your calculations) 2.1% On a bright Friday afternoon, Benjamin sat in his office reflecting on a meeting he had with an investment banker earlier in the week. The banker, whom Benjamin had known for years, asked for the meeting after a group of private equity investors made discreet inquiries about a possible acquisition of HD. Although HD was a public company, a majority of its shares were controlled by family members descended from the firm's founders together with various family trusts. Benjamin knew the family had no current interest in selling - on the contrary, HD was interested in acquiring other companies in the same industry - so this overture, like a few others before it would be politely rebuffed Nevertheless, Benjamin was struck by the banker's assertion that a private equity buyer could "unlock" value inherent in HD's strong operations and balance sheet. Using cash on HD's balance sheet and new borrowings, a private equity firm could purchase all of HD's outstanding shares at a price higher than its current stock price of $114.33 per share. It would then the debt over time using the company's future earnings. The banker pointed out that HD itself could do the same thing - borrow money to buy back its own shares. In the days since the meeting, Benjamin's thoughts kept returning to a share repurchase. Working as the analyst for the company, you are asked to prepare a report to explain the pros and cons of this deal. Here is a draft of your report. Next you show Benjamin the impact of the investment banker's share repurchase proposal: the company could raise $10 billion new debt at the current rate of 2.1% to repurchase its own shares. Payout policy (4 Mark) 7. Given that HD currently has an 80% dividend payout policy, you also show the interest income to lenders, and dividend income to shareholders, assuming both types of investors pay personal tax at 40% in each of the following tax environment: 1) the classic tax system; and 2) the imputation tax system. Explain which tax system is preferable theoretically. 1 2 Question 7 3 AFTER REPURCHASE 4 All figures in 000s Classic tax system Imputation tax system 5 Income Statement 6 EBIT 7 Less: Interest expense 8 Earnings Before Tax 9 Less: Taxes 10 Net Income 11 12 SHAREHOLDERS' ACCOUNT (at 80% payout ratio) 13 NI available for shareholders 14 Less: Taxes @ 40% 15 Plus: Franking credit 16 SH's ditributable funds 17 18 LENDER'S ACCOUNT 19 Interest earned 20 Less: personal taxes @ 40% 21 Lender's ditributable funds 22 23 DISTRIBUTABLE FUNDS 24 Shareholders after tax 25 Lenders after tax 26 Total distributed funds 4,662,282 6,897,624 27 28 29 Income Statement (000s) 30 Period Ending: 31/12/2019 31 Total Revenue 83,176,000 32 Cost of Revenue 54,222,000 33 Gross Profit 28,954,000 34 35 Operating Expenses 36 Sales, General and Admin. 21,884,200 37 Other Operating Items 2,146,300 38 Operating Income 13,609,700 39 Add'l income/expense items 438,100 40 EBIT 14,047,800 41 Interest Expense 1,079,000 42 Earnings Before Tax 12,968,800 43 Income Tax 4,720,300 44 Net Income-Cont. Operations 8,248,500 45 Net Income Applicable to 46 common shareholders 6,598,800 47 48 HD's business HD was a large producer of branded appliances primarily used in residential households. For the period 2015-2019 the industry posted modest annual unit sales growth of 1.8% despite positive market conditions including a strong housing market and product innovations. Competition from inexpensive imports and aggressive pricing by Mass Merchandisers Limited has reduced growth to 2.5% annually over the period. Under its CEO Benjamin White's leadership, HD operated much as it always had, with three notable exceptions. First, the company completed an IPO (Initial Public Offering) in 2014. This provided a measure of liquidity for founders' descendants who, collectively, owned 62% of the outstanding shares following the IPO. Second, beginning in the 2010s, HD has gradually moved its production abroad. Finally, HD had undertaken a strategy focused on rounding out and complementing its product offerings by acquiring small independent manufacturers and/or the kitchen appliance product lines of large diversified manufacturers. Thus far, all acquisitions had been for cash or HD stock. HD's historical performance During the year ended December 31, 2019, HD earned net income of $8.25 billion on revenue of $83.18 billion. Exhibits 1 and 2 present the company's recent financial statements. The company's 2019 EBIT margin of nearly 7.0% was average within the peer group. During 2015- 2019, compounded annual returns for HD shareholders (including dividends and stock price appreciation) was approximately 11.1% per year. This was higher than the ASX S&P200, which returned approximately 5% per year. However, it was well below the 16% annual compounded return earned by shareholders of HD's peer group during the same period. HD's financial policies HD's financial position was conservative and very much in keeping with HD's long- standing practice and, with its management style. In recent years the company's largest uses of cash Page 1 of 7 have been common dividends and cash consideration paid in various acquisitions. Dividends per share had risen only modestly during 2015-2019. However, as the company issued new shares in connection with some of its acquisitions, the number of shares outstanding increases to approximately 1.27 billion by the end of 2019. Net income (000s) Average number of shares outstanding (000s) Effective corporate tax rate Average cost of bonds 31/12/2019 8,248,500 1,267,881 36.50% (use this rate in your calculations) 2.1% On a bright Friday afternoon, Benjamin sat in his office reflecting on a meeting he had with an investment banker earlier in the week. The banker, whom Benjamin had known for years, asked for the meeting after a group of private equity investors made discreet inquiries about a possible acquisition of HD. Although HD was a public company, a majority of its shares were controlled by family members descended from the firm's founders together with various family trusts. Benjamin knew the family had no current interest in selling - on the contrary, HD was interested in acquiring other companies in the same industry - so this overture, like a few others before it would be politely rebuffed Nevertheless, Benjamin was struck by the banker's assertion that a private equity buyer could "unlock" value inherent in HD's strong operations and balance sheet. Using cash on HD's balance sheet and new borrowings, a private equity firm could purchase all of HD's outstanding shares at a price higher than its current stock price of $114.33 per share. It would then the debt over time using the company's future earnings. The banker pointed out that HD itself could do the same thing - borrow money to buy back its own shares. In the days since the meeting, Benjamin's thoughts kept returning to a share repurchase. Working as the analyst for the company, you are asked to prepare a report to explain the pros and cons of this deal. Here is a draft of your report. Next you show Benjamin the impact of the investment banker's share repurchase proposal: the company could raise $10 billion new debt at the current rate of 2.1% to repurchase its own shares
