You are asked to provide financial advice to potential shareholders of both companies. Based on your analysis in questions 2 and 3, which share would you advise investors to buy, and which would you advise to sell or exercise caution on? Explain your answer. (2 marks)

QUESTION 1: Calculate the Cash Conversion Cycle (CCC) for each of the two companies in 2015 and 2016. Using your answer, analyse the efficiency of each of the two companies in managing their working capital in 2016 as compared to 2015. Note: ensure that you analyse in this question, not just describe the CCC values. The following data expresses the calculated CCC of companies ERM Power Limited (EPW) and Mercury NZ Limited (MCY): Year EPW MCY 201 5 -11.8 -8.92 201 6 -4.36 -3.37 Through studying the calculations and the cash conversion cycles of companies ERM Power Limited (EPW) and Mercury NZ Limited (MCY) as displayed in the above table, the efficiency of the two companies in managing their working capital is made exceedingly evident. By observing the CCC of EPW, it is signified that it has increased from -11.8 in 2015 to -4.36 in 2016. By maintaining a negative CCC, this illustrates that EPW have paid for their product before paying for the cost of producing it and is in a strong position with their suppliers (textbook reference). Essentially this shows that EPW is managing their working capital quite efficiently and dealing with their cash, inventory, receivables and payables significantly well. However, when comparing the CCC of EPW in 2015 to 2016, there is a clear increase. Through analysing the company's calculations, it is made evident that their inventory days have dropped, which means their products are being sold faster, and their accounts payable days have accumulated as they are taking 4.26 days longer to pay their accounts. However the big change is identified through EPW's receivable days as they are taking 14.75 days longer in 2016 to receive (DatAnalysis reference). Therefore it is indicated that the CCC has increased from 2015 to 2016 due to the reason that the are selling their inventory faster and receiving cash slower. This information essentially signifies that EPW managed their working capital more efficiently in 2015 and need to implement more working capital management strategies in order to maintain become more efficient. The CCC of MCY has also experienced an increase from -8.92 in 2015 to -3.37 in 2016. As it is negative, MCY also shows efficient management of working capital as they have paid for the product before paying production costs and are in good circumstances with suppliers (textbook reference). However it is made evident that when comparing the CCC of MCY in 2015 to 2016, just like EPW, MCY's CCC has increased. By examining the calculations of MCY's cash conversion cycle, it is perceptible that inventory days have increased by 8.3 days and they are also taking 5 days longer to receive cash as well as a 7.75 day increase in payable days (DatAnalysis reference). In comparison to 2015, this significantly indicates that MCY are taking longer to sell their products and pay off accounts. Although the company is in a good position with a negative cash conversion cycle, this shows that they must also administer more strategies in order to continue to efficiently manage their working capital. QUESTION 2: a) Analyse the capital structure for each of the two companies in 2016 as compared to 2015. Use two capital structure ratios to support your answer and explain any change in the sources of finance for each enterprise. Note: ensure that you analyse in this question, not just describe the ratio values. Capital Structure - the way a firm finances its assets using a combination of debt and equity How has the firm financed the purchase of its assets? Debt Ratio - measures the proportion of the firm's assets that were financed by borrowing or debt financing o Higher the ratio indicates a greater reliance or non-owner financing or financial leverage Interest Coverage Ratio - looks at the firm's ability to pay the interest expense on its debt o Higher the ratio indicates that the firm's ability to pay its interest in a timely manner is greater Pg 163 Capital Structure is used to determine how a firm is to finance its assets through their debt and equity. The ratios used here to analyse the capital structure are the Debt-to-equity ratio and the Interest Coverage ratio. The Debt-to-equity ratio determines whether the company is capable of paying their debt without impacting their profitability (textbook reference). From 2015 to 2016 ERM Power Limited had decreased from 1.89 to 1.63 therefore by their ratio decreasing so does their financial leverage. The decrease in the ratio has resulted from their equity increasing in 2016 from 319,716,000 to 471,403,000 whilst the liabilities have increased from 605,301,000 to 767 321 000. Here there is almost half the equity increasing and only about 27% increasing of the liability. Therefore if the liabilities continue to climb at a slow rate and the equity increases rapidly, the debt-to-equity ratio of ERM will continue to decrease benefitting the company. From 2015 to 2016 for Mercury NZ there hasn't been a significant change for the debt-toequity ratio compared to ERM Power Limited. As is the same with their Interest Coverage ratio, both figures show that the company has had a steady growth. In further depth, it is evident that the equity from 2015 to 2016 has increased from 2,954,666,194 to 3,160,453,809 and their EBIT has increased from 263,865,915 to 306,034,893. Therefore this improvement in the debt Debt-to-equity ratio: Total Liabilities Total Equity Interest Coverage Ratio: Operating Profit or EBIT Interest Expense ERM Power Limited 2015 Debt-to-equity ratio: 605,301,000 / 319,716,000 = 1.89 Interest Coverage Ratio: 167,273,000 / 27,293,000 = 6.13 (EBIT decreased significantly from 2015-2016 167 mil to 01 mil respectively and this has resulted in the interest coverage ratio halving over the same time period) ERM Power Limited 2016 Debt-to-equity ratio: 767 321 000/471 403 000 = 1.63 2016 Liability - 2015 Liability 767 321 000 - 605,301,000= 162,020,000 Difference / 2015 Liability 162,020,000 / 605,273,000 = 0.27 2016 Equity - 2015 Equity 471,403,000 - 319,716,000= 151687000 Difference / 2015 Equity 151,587,000 / 319,716,000 = 47% Interest Coverage Ratio: 91 420 000/29 124 000 = 3.14 (Their ability to service the interest expense on their debt) (Over this period of time it can be seen that the trend is worsening and should be a key concern to address in the near future) - EBIT decreased significantly causing the interest coverage ratio to decrease Mercury NZ Limited 2015 Debt-to-equity ratio: 2,409,243,846/2,954,666,194 =0.82 (it can be seen from 2015 - 2016 that the trend remains steady with reference to the debt to equity ratio. In further depth the level of debt in 2015 is 2.4mil and has increased to 2.64mil in 2016. Similarly the level of equity has increased from 2.95mil to 3.16mil which has resulted in marginally decreased debt to equity ratio but not significantly enough to cause concerns. Interest Coverage Ratio: 263,865,915/92,084,292 = 2.87 Mercury NZ Limited 2016 Debt-to-equity ratio 2,640,861,855/3,160,453,809 = 0.84 Interest Coverage Ratio: 306,034,893/95,337,973 = 3.21 b) Assume that the average debt ratio for the Electric Utilities industry in 2016 was 45 Per cent. What can you conclude about each of the two firm's' current capital structure and gearing (leverage) effect in 2016 as compared to the industry average? (3 marks) There is a significant difference when comparing the debt ratios of ERM Power Limited (2016) and Mercury NZ (2016) when compared to the Electric Utilities Industry of 45%. The ERM Power Limited (2016) compared to the industry average of 45% is higher at 61.49% therefore it is considered a bad debt ratio. This could have occurred due to the accounts payable of ERM in 2016 which increased significantly from previous years. By the accounts payable increasing has resulted in the company taking longer to pay off their accounts, resulting in their debt increasing. Mercury NZ Limited's Debt ratio however is on par with the industry average for 2016 at 45.52% therefore they would be considered a lower risk for financial institutions as their percentage is relatively the same. By Mercury NZ continuing to service their own debt at this rate they will continue to be considered within the good debt ratio. The difference here to ERM Power Limited would be the small increase to their accounts payable therefore they are still paying off their accounts relatively within the same period. In terms of risk, the lower the ratio the better since interest on debt must be paid back regardless of the business profitability. Therefore by Mercury being on par with the industry percentage they are paying off their interest without it impacting their profitability whereas ERM having a higher ratio results in higher interest payments which impacts their earning per share. Therefore Mercury Limited is in a better capital structure when compared to ERM Power Limited in 2016. DEBT RATIO = Total Liabilities Total Assets ERM Power Limited 2016 Debt Ratio 767 321 000 / 1 238 724 000 = 61.94% Mercury NZ Limited 2016 Debt Ratio 2 640 861 855 / 5 801 315 664 = 45.52% QUESTION 3: a) Using the DuPont method, analyse the profitability of each of the two companies in 2015 as compared to 2016 from a shareholder's point of view. Based on your calculations, explain the main reason(s) for the change in the profitability for each company over the two years. Note: ensure that you analyse in this question, not just describe the ratio values. (3 marks) From a stakeholders perspective the overall profitability of ERM Power Limited (EPW) has decreased between 2015 and 2016. The main reason for this decline in profitability is due to the decreased efficiency in the use of their assets. A DuPont analysis has shown that their return on equity has dropped from 0.21 in 2015 to 0.08 in 2016. This drop was mainly caused by a large increase in assets however their sales have stayed relatively stagnate. The profitability of Mercury NZ Limited (MCY) has increased between 2015 and 2016. This increase is due to their ability to reduce their overall costs subsequently increasing their profitability . This is shown in the DuPont analysis where all the figures for 2015-2016 have stayed stable apart from the net profit which has seen a significant increase in 2016. This is shown in the return on equity going from 0.01 in 2015 to 0.05 in 2016. b) Comparing both companies' profitability in 2016, state one area that might help the management of each company in improving their profitability in 2017. (2 marks) If you compare both ERM Power Limited (EPW) and Mercury NZ Limited (MCY) you can see that EPW have higher costs than MCY however MCY are not utilising their assets as effectively as EPW. EPW can improve their profitability by decreasing their costs. One possible solution is to expand their business operations to benefit from economies of scale. Larger companies tend to be more efficient & profitable & can be an effective long term strategy. MCY can improve their profitability by increasing efficiency. A solution for this would be to look into automating some of their manual processes. This in turn would increase their efficiency. QUESTION 4: a) Calculate each company's price-earnings ratio and market-to-book ratio as at 30 June 2015 and 30 June 2016. Over the two years, what do these ratios tell you about how investors value each of the firm's assets and future prospects? Explain. (2 marks) Price-earnings ratio = Market price per share Earnings per share Market-to-book ratio = Market price per share = Market price per share Book value per share (Ordinary shareholders' equity) Ordinary shares outstanding A) EPW 2015 Price-earnings ratio = 2.320 / (EPS = 65,937,000 / 239,477,023 = 0.28) = 2.320 / 0.28 = 8.29 Market-to-book ratio = 2.320 / (319,716,000 / 239,477,023) =1.74 EPW 2016 Price-earnings ratio = 0.840 / (EPS = 35,809,000 / 242,465,421 = 0.15) = 0.840 / 0.15 = 5.6 Market-to-book ratio = 0.840 / (471,403,000 / 242,465,421) =0.04 MCY 2015 Price-earnings ratio = 2.50 / (EPS = 41,615,017 / 1,400,012,517 = 0.03) = 2.50 / 0.03 = 83.33 Market-to-book ratio = 2.50 / (2,954,666,194 / 1,400,012,517) =1.18 MCY 2016 Price-earnings ratio = 2.88 / (EPS = 152,540,757 / 1,376,012,517 = 0.11) = 2.88 / 0.11 = 26.18 Market-to-book ratio = 2.88 / (3,160,453,809 / 1,376,012,517) = 1.25 B) You are asked to provide financial advice to potential shareholders of both companies. Based on your analysis in questions 2 and 3, which share would you advise investors to buy, and which would you advise to sell or exercise caution on? Explain your answer. (2 marks) Tba APPENDIX 1)a) CCC = Inventory days + receivable days - payable days Inventory days = inventory balance/(COGS/365) Receivable days = accounts receivable balance/(sales/365) Payable days = accounts payable balance/(COGS/365) ERM Power Limited 2015 Inventory Days = 36,433,000/(2,173,704,000/365) Inventory Days = 6.12 Receivable days = 218,305,000/(2,750,665,000/365) Receivable days = 28.97 Payable days = 279,239,000/(2,173,704,000/365) Payable days = 46.89 CCC = 6.12+28.97-46.89 CCC = -11.8 ERM Power Limited 2016 Inventory Days = 22,082,000/(2,618,980,000/365) Inventory days = 3.08 Receivable Days = 330,596,000/(2,760,665,000/365) Receivable days = 43.71 Payable Days = 367,043,000/(2,618,980,000/365) Payable days = 51.15 CCC = 3.08+43.71-51.15 CCC = -4.36 Mercury NZ Limited 2015 Inventory days = 26,562,777 / (845,581,730 / 365) Inventory days = 11.47 days Receivable days = 159,376,660 / (1,440,588,000 / 365) Receivable days = 40.38 days Payable days = 142,553,568 / (845,581,730 / 365) Payable days = 60.77 CCC = 11.47 + 40.38 - 60.77 CCC = -8.92 days Mercury NZ Limited 2016 Inventory days = 42,902,088 / (792,258,560 / 365) Inventory days = 19.77 days Receivable days = 179,235,389 / (1,441,510,000 / 365) Receivable days = 45.38 days Payable days = 148,727,238 / (792,258,560 / 365) Payable days = 68.52 days CCC= 19.77+45.38-68.52 CCC = -3.37 days 2)a) 3)a) DUPONT ANALYSIS (ROE): Net Profit x Sales x Total Assets Sales Total Assets Ordinary Equity (Profitability) (Efficiency) (Equity Multiplier) ERM Power Limited 2015 DuPoint Analysis: = (65,937,000 / 2,750,665,000) x (2,750,665,000 / 925,017,000) x (925,017,000 / 319,716,000) =0.02 x 2.97 x 2.89 =0.21 ERM Power Limited 2016 DuPoint Analysis: =(35,809,000 / 2,760,665,000) x (2,760,665,000 / 1,238,724,000) x (1,238,724,000 / 471,403,000) =0.01 x 2.23 x 2.63 =0.08 Mercury NZ Limited 2015 DuPoint Analysis: =(41,615,017 / 1,440,588,000) x (1,440,588,000 / 5,363,910,041) x (5,363,910,041 / 2,954,666,194) =0.03 x 0.27 x 1.82 =0.01 Mercury NZ Limited 2016 DuPoint Analysis: =(152,540,757 / 1,441,510,000) x (1,441,510,000 / 5,801,315,664) x (5,801,315,664 / 3,160,453,809) =0.11 x 0.25 x 1.84 =0.05 4)a) EPW 2015 Price-earnings ratio = 2.320 / (EPS = 65,937,000 / 239,477,023 = 0.28) = 2.320 / 0.28 = 8.29 Market-to-book ratio = 2.320 / (319,716,000 / 239,477,023) =1.74 EPW 2016 Price-earnings ratio = 0.840 / (EPS = 35,809,000 / 242,465,421 = 0.15) = 0.840 / 0.15 = 5.6 Market-to-book ratio = 0.840 / (471,403,000 / 242,465,421) =0.04 MCY 2015 Price-earnings ratio = 2.50 / (EPS = 41,615,017 / 1,400,012,517 = 0.03) = 2.50 / 0.03 = 83.33 Market-to-book ratio = 2.50 / (2,954,666,194 / 1,400,012,517) =1.18 MCY 2016 Price-earnings ratio = 2.88 / (EPS = 152,540,757 / 1,376,012,517 = 0.11) = 2.88 / 0.11 = 26.18 Market-to-book ratio = 2.88 / (3,160,453,809 / 1,376,012,517) = 1.25 References