49h: manipulating return-on-equity

CFA Level I Equities
#1

Return on equity is supposed to be

A) the increase in equity

divided by

B) the book value of a firm

In the textbook, they claim "A firm can also issue debt to repurchase equity, thereby decreasing the book value of equity." How would issuing debt successfully manipulate the return on equity ratio?

Let’s pretend that my company has $100 in assets and $30 in liabilities. We agree that book value (equity) = $70, right?

Now let’s say that my companies borrows $20 (either through a bank or by selling bonds to public investors). Explain to me how that manipulates the ROE. You’ve just increased liabilities by $20 and used the money to buy $20 in new assets. The book value is still the same $70, and net income is still the same. So ROE is static, right?

#2

ROE = Net Income / Average Total Equity

We know that accounting equation is Assets = Liabilities + Equity

Considering your example: Raise funds via debt

We have that: Assets(100) = Liabilities (30) + Equity (70) ------------(1)

After new debt has been issued, the proceed of 20 will be used to purchase new assets

(1) becomes Assets (100_ +20 ) = Liabilities (30 +20 _) + Equity (70)------(2)

In which case, equity still stand at 70 and hence ROE remain the same.

_ Now, if we consider what the textbook said: Repurchase equity with debt: _

From (1): Assets(100) = Liabilities (30) + Equity (70)

The firm use the proceeds from bond issuance to repurchase equity, the no.of outstanding shares now fall by similar amount

Assets(100) = Liabilities (30_ +20 ) + Equity (70 -20 _)---------(3)

Based on (1) ROE = Net Income/ 70

Based on (2) ROE = Net Income/ 70

Based on (3) ROE = Net Income/ 50

It’s obvious from equation (3) that ROE has increased. This is what the textbook is trying to explain- by reducing the book value of the firm’s equity, ROE has been manipulated in favor of the firm.

Note that in our examples thus far, we are using the book value i.e. balance sheet values and not market values.

Hope this helps.

Cheers,

Ernest

#3

Remember the three-factor DuPont formula:

ROE = NI/Equity

= NI/Sales × Sales/Assets × Assets/Equity

Thus, you can increase ROE by:

  • Increasing profit margin (NI/Sales)
  • Increase asset turnover (Sales/Assets)
  • Increasing leverage ratio (Assets/Equity)

Issuing debt to repurchase stock reduces equity, thus increasing leverage. This increases ROE by increasing risk.

#4

This helped a little, but I still don’t understand how repurchasing shares from the public affects equity. (I don’t have a background in corporate finance).

#5

A company could reduce equity both by repurchasing some of the O/S shares and retiring them, and additionally could reduce retained earnings if they repurchase the common shares for greater than the weighted average issuance cost the debit (plug) hits retained earnings, which will further decrease shareholder’s equity and improve ROE

#6

The equity section of a corporate balance sheet generally contains these accounts:

  • Common stock (at par)
  • Additional paid-in capital
  • Retained earnings

In addition, it may contain any of these accounts:

  • Preferred stock (at par)
  • Other comprehensive income (OCI)
  • Treasury stock (a negative value)

Common stock is the number of shares of stock that the company issued, multiplied by the par value. (The par value is, essentially, a random number that the company chose before they sold any stock; it generally has nothing to do with the price investors pay for the stock. It’s usually a round number, such as $10/share, or $50/share.)

Additional paid-in capital is money that investors paid the company above the par value of the stock. If the par value were $10/share, and in the IPO investors bought stock for $30/share, then the additional paid-in capital would be $20/share (= $30/share – $10/share) multipied by the number of shares issued.

Retained earnings is the accumulated net income that hasn’t been paid out in dividends.

If a company buys back its own stock, that goes into the Treasury stock account. This is an unusual account: its balance is a negative number; it reduces equity. If the company bought back 1,000 shares of its stock, and that stock has a par value of $100/share, then its equity section will list Treasury stock with a value of ($100,000): negative $100,000. (If they pay some price other than $100/share on the open market when they repurchase the shares, I believe that the difference goes into additional paid-in capital. It’s been a long time since I got my accounting degree, so I may be mistaken on this, but it sounds reasonable.)

Thus, if a company issues $1,000,000 in bonds (a liability) and uses that money to repurchase its own shares, then its liabilities will increase by $1,000,000 (bonds payable), and its equity will decrease by $1,000,000 (Treasury stock and paid-in capital).