Report On Arb Corporation Limited Assessment Answer

ee, Liang, & Miglo, 2014).

• Determine ARB’s debt to equity ratio.
• Perform comparison of debt/equity ratio with other similar companies in the motor vehicle assembly industry.
• Determine ARB’s optimal capital structure
• Determine ARB’s Weighted Average Cost of Capital.
• Compare ARB’s capital structure over past three years.

Total Debt to Equity Ratio

The total debt to equity ratio measures the relationship between equity capital and debt. A high ratio suggests that a company has taken more debt and consequently, is more aggressive with a higher risk (Investopedia, 2018).

In 2017, ARB’s debt to equity was nil as the company did not take any debt.

Weighted Average Cost of Capital

The WACC (also known as Weighted Average Cost of Capital) is the expected return on the securities for a company.

WACC = Weight Debt * cost of debt *(1 – corporate tax) + Weight equity *cost of equity           

The components of the WACC are as follows:-

• Cost of equity
• Cost of debt
• Corporate tax rate
• Weight of Equity
• Weight of Debt

1. Cost of Equity

The cost of equity, R_e can be determined from Capital Asset Pricing Model

R_e = r_f +β(r_m –r_f)

Where r_{f =} Risk free rate, β= Beta, (r_m –r_f)= Risk premium

In 2017, assuming the firm has a Beta of 0.89 and the capital return on the market was 8.54%, then the cost of equity for ARB was 7.39% (see appendix).

2. Cost of Debt

To calculate the cost of debt we need to divide the total debt by the interest expense. In 2017, the cost of debt for ARB was nil given it had no debt.

3. Corporate Tax

As stated in their 2017 audited financial statements, it can be assumed that the applicable corporate tax rate is 30%.

4. Weigh of Debt and Equity

To determine the Weights of Equity and Debt, we require the market value of Equity (E) and the book value of Debt (D).

The market value of Equity is the current share price, P₀, multiplied by the number of shares outstanding. These data is available from Yahoo! Finance (Yahoo Finance, 2018).

The book value of Debt (D) can be obtained from the Balance Sheet. In 2017, D was nil.

Weight of Debt, W_d= D/D+E = 0%

Weight of Equity, W_e= E/D+E = 100%

5.Weighted Average Cost of Capital

In order to determine the optimal capital structure of ARB, we need to determine ARB ’s Weighted Average Cost of Capital.

WACC =Weight Debt * cost of debt *(1 – T) + Weight equity *cost of equity

Where T is the corporate tax

We calculate the WACC for ARB as 7.39%.

Comparison of Capital Structure to Industry

Both ARB and Bapcor Ltd are listed companies in the automotive parts industry (Bapcor Ltd, 2018).

Similarly, the current capital structure for Bapcor Ltd can be analyzed from the Debt to Equity Ratios. In 2017, Bapcor’s debt to equity ratio for was 0.74. This was significantly higher than the debt to equity ratio of ARB suggesting ARB is rated below average among related companies.

ARB Financial Ratio Analysis

A company’s financial ratios provide investors with information on its profitability, solvency, growth, liquidity and efficiency. Table 2-1 shows various ratios for ARB over three years.

Table 2?1: Financial Ratios- ARB s

Financial Ratios	2017	2016	2015
Return on Equity	18.83%	18.45%	-
Return on Assets	15.77%	-	-
Debt to Equity Ratio	0	0	0
Current Ratio	3.4	3.63	3.15
Quick Ratio	1.63	1.50	1.32

Source- ARB Financial reports and The Wall Street Journal

Liquidity

These ratios determine the liquidity risk for the company i.e their ability to pay current liabilities. They include current ratio and quick ratio (Subramanya & Wild, 2009). In 2017, ARB had a current ratio of 3.4 and a quick ratio of 1.63. A ratio above 1 suggests greater assurance that ARB’s current liabilities can be paid using its current assets, thus the company does not have a liquidity risk problem

Solvency

Solvency Ratios determine if a company a company can meets its long term liabilities. They include time interest earned and debt to equity ratio. In 2017 and 2016, the debt to equity ratio has been nil suggesting they have little debt and thus low risk.

Profitability

These ratios measure whether a company is profitable. They include return on asset and return on equity (Subramanya & Wild, 2009).  In 2017, ARB had a return on asset of 15.77% and return on equity of 18.83%. Since the ratio is high and is increasing each year then ARB is doing well.

ARB’s Capital Structure over Past Three Years

We note for year 2016 and 2015, the capital structure was 0%debt/100%equity and 0%debt/100%equity respectively. This suggests that the company has maintained its capital structure for the past three years.

Creation of Shareholder Wealth and Minimizing Cost of Capital

Since ARB ’s current structure is at its optimal capital structure of 0% debt and 100% equity, the company has been creating value for three years. Furthermore, it is evident the company has performed well in the short term in terms of growth and profitability as evidenced by their financial ratios.

One of the ways a firm can increase its share price, and hence create value for shareholder’s is by minimizing its cost of capital. Thus it is important that the firm targets an optimal capital structure. An alternative capital structure which also minimizes the cost of capital is via asset based lending.

Conclusion- Shareholder Value

Shareholder wealth maximization involves increasing the share price. One of the ways to create value in a firm is by utilizing an optimal capital structure.

In the case for ARB ’s, we can see that indeed the company is at its optimum capital structure of 0% debt and 100% equity. Furthermore, their key ratios indicate that the company is making profits, its ROE is greater than the WACC and they don’t seem to have any liquidity/solvency risk.

In conclusion, ARB does appear to be creating maximum value for its shareholder’s as evidenced from its high ROE. It should continue to aim to minimize its cost of capital so that the firm’s value is maximized in the long run. Some of the ways ARB can minimize its WACC include lowering its interest rates and managing its operational risks.

References

Bapcor Ltd. (2018). About Us. Retrieved from Bapcor Ltd: https://www.bapcor.com.au

Investopedia. (2018). Debt/Equity Ratio. Retrieved from Investopedia: https://www.investopedia.com

Lee, Z., Liang, S., & Miglo, A. (2014). Capital Structure of Internet Companies: Case Study. Retrieved from https://faculty.nipissingu.ca/antonm/files/2014/06

Subramanya, K., & Wild, J. (2009). Financial Statement Analysis. New York: McGraw-Hill Irwin.

Yahoo Finance. (2018). ARB CORPORATION LIMITED. Retrieved from Yahoo Finance: https://au.finance.yahoo.com