As we know, the amount of leverage (fixed costs assets or funds) use by the firm will directly affects its return, risk and share value. Generally, higher leverage raises risk and return, whereas, lower leverage reduce risk and return. The degree of operating leverage (DOL) is measure the sensitivity of changes in EBIT to changes in sales. Thus, the DOL is 4.86 and shows us that there is operating leverage in Hup Seng Industries Bhd as there is greater than 1.Below is the table of DOL.
Whereas, the financial leverage is used of fixed financial costs to magnify the effects of changes in EBIT on the firm's EPS. Thus, the DFL is 1.19 and shows us that there is financial leverage in Hup Seng Industries Bhd. Below is the table of DFL.
Total leverage shows us that the result of combined effect of using fixed costs, both operating and financial to magnify the effects of changes in sales on the firm earning per share. Thus, the DTL is 5.78 and shows us the total leverage is existing in the firm. Below is the table of DTL.
The DOL, DFL and DTL show us that the Hup Seng Industries Bhd has depended on leverage. Leveraging is a way to use funds whereby most of the money is raised by borrowing rather than by stock issue or use of capital .Sometimes, it is also bring benefit to the firm as the firm can invest the money and hoping the investment makes more money than the firm will have to pay in interest on the loan. Thus, they no need to issue stock and use of their own capital.
The firm DOL is 4.86 which is quite moderate because of not exceed 5, thus, this also show us that the firm has low risk. As a result, the firm is more stable and less likely to default on its operating expenses. This may due to the reason of the firm can easily estimated its financial situation and find the potential problems in future. As we know, the higher the value of DOL, the higher the degree of operating leverages. Thus, the firm will hard to estimate how much money it will need and make, and will also miscalculate the business risk .In the long run , it will affect the firm profitability and may be at risk of bankruptcy if they are unable to make payments on their debt on time and unable to find new lenders in the future .
The firm DFL is 1.19, which is quite low .Thus, the firm not faces the difficulty in paying interest and principal while obtaining more fund as well as not decrease the firm returns on equity and profitability. As we know, financial leverage arises when a firm decides to finance a majority of its assets by taking on debt instead by issuing shares in the market to meet their business needs. Moreover, the financial leverage is not always bad, because it can increase the shareholders' return on their investment and also tax advantages associated with borrowing.
Capital Structure of Hup Seng Industries Bhd
Debt capital and equity capital make up a firm's capital structure. Normally, the sources of fund contribute to the capital structure of corporations are long term debt, preferred stock and common stock equity.
Through the analysis of balance sheet of Hup Seng Industries Bhd, we know that debt ratio of the company is 0.24:1, also =24% , which is quite low and is in a good position which was likely by the creditors as a cushion against loss. This also means that 24% of firm is financed by debt financing and 76% of the firm's assets are financed by the investors or by equity financing. The lower the ratio show by the Hup Seng, the lower the firm's degree of indebtedness and the lower the financial leverage. Low financial leverage is a favourable leverage because its earnings are more than what the debt would cost. Furthermore, low leverage will help decrease the firm risk and rate of interest. Thus ,return on shareholder earnings are more stable and predictable than those for companies with more debt because of the reason make less interest and principal payment on debt. The operating income of the firm will be sufficient to cover the fixed charges on debt.
Via DuPont System of analysis, we know that ROA is 14.4%. Hup Seng Industries Bhd has a high return on total asset , which is better and shows us that the firm effectiveness of use the available asset to generate the firm profit .Whereas the ROE is 33% which show us that the return on common equity quite high and it is good for the owners. Hup Seng has moderate ROE may be result of the quick collections of account receivable, which result in lower level of receivables and therefore lower level of total assets. The lower the total asset quicken Hup Seng's total asset turnover, push up the ROA and then push up its ROE.
Debt ratio
DuPont system of analysis
Total liability /total asset
=$45,469,434/$187,130,994
=24%
ROA =net profit margin x
total asset turnover
=12.63% x1.14
=14.4%
ROE=ROA x FLM
=ROA x Total asset
turnover
=14.4% x 2.29
=33%
New Project Impact to Hup Seng Industries Bhd
Project Milo Sweetie Cake and Project Coolscuit are the 2 projects we intend to introduce to Hup Seng which will increase the wealth of shareholders of Hup Seng Industries Berhad's. But finally ,we prefer the Project Milo Sweetie Cake because of higher NPV that is RM 80,090.03 than than NPV of Project Coolscuit that is RM 24 098.40.
The initial investment of Project Milo Sweetie Cake is RM 451,000. Thus, we will use the combination of long-term debt, common stock and retained earnings to raise funds for these projects. We need to use the debt of RM300, 000, common stock of RM100, 000 and the retained earnings of RM51, 000. As a result, the total debt will increase while the liability will increase as well by paying with the interest rate .There will be a RM 173,240 total cash inflows from year 1 until year 6 to the firm if the firm implement the Project Milo Sweetie Cake. Furthermore, Hup Seng Industries Berhad's is advised to buy the new machine which cost around RM 430,000 if intend to implement Project Milo Sweetie Cake. As we know, the new machine will perform better and faster than the existing machine. Thus, it can bring more profit to the firm.
In this project, we use 75% of debt and 25% of common stock compare with before we implement the project which is use 24% debt financing and 76% of the common stock. If the firm accept this project, it will increase debt of firm to 51%, but it doesn't means that it is a bad new to the company. This is because of the reason the firm can use the debt to push up the ROE as the firm before implement the project the ROE is only 33%. As we know, the higher the ROE, the better to the firm.
Moreover, if the firm finances the business by using debt, the interest the firm pay is tax-deductible. This means it shields part of the business income from taxes and lowers the firm tax liability in every year rather than the equity financing which use double -taxation. Debt is normally the cheapest form of long-term financing. Thus, it is a desirable component of the firm's capital structure as long as the borrowed funds produce a return higher than of their cost. In additions, during the inflation period, the company will be paying back the debt with cheaper than before.
Hup Seng Industries Bhd should implement this Project Milo Sweetie Cake by consider take the debt as it believe that return on asset will be higher than by taking the loan.If the firm EBIT is greater than interest of financial leverage, then it is better for the company to take debt as it can generate positive cash flows to the firm. But, using too much debt is also create a problem to the firm because it increases the perceived risk associated with businesses, thus making the firm unattractive to investors and finally reducing their ability to raise additional capital in the future and may be face bankruptcy because of inability to meet its obligation.
As a nutshell, Hup Seng Industries Bhd should accept this Project Milo Sweetie Cake as it will generate higher profit to the firm as well as increase the market value of the company and therefore the wealth of its shareholder.
