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General Electric (GE) company Essays

General electric (ge) company

A leading company in terms of wealth creation, profitability and soundness of operations, General Electric (GE) has consistently reaped commendable figures in its financial reports through the years and has good reasons for believing that 2008 will turn out to be yet another great year.  In the 2007 GE Annual Report, a statement from the company’s management goes, “In 2008, we should hit all of our financial goals and outperform the S&P 500.  Our revenues should grow by at least 10% to $195 billion, with organic revenue growth by at least 10%.  Our return on average total capital (ROTC) should near our target of 20%.  We expect to return $18 billion to our investors through the dividend and stock buyback.”  (2007 GE Annual Report)
The market capitalization of GE for the years 2007 and 2006 is computed as follows:
Particulars
2007
2006
Year-end Closing Market Prices (in $)
37.07
37.21
End of period common shares outstanding-ave.
10,182,083,000
10,359,320,000
Total market value of common stocks (in $)
377,449,816,810.00
385,470,297,200.00
The year-end closing market prices are taken from the Yahoo! Finance website.
The end of period common shares outstanding figures are taken from the 2007 & 2006 GE Annual Reports

Most firms raise a substantial portion of their capital as long-term debt, and many also use preferred stock.  For these firms, the cost of capital must reflect the average cost of the various sources of long-term funds used, not just the firms’ cost of equity.   Thus, the Weighted Average Cost of Capital or WACC is the weighted average of the component costs of debt, preferred stock, and common equity.  The weights assigned for the debt, preferred shares and common equity are to be based on the proportions targeted by the company for such capital items.  WACC is equal to the weight used for debt multiplied by after-tax cost of debt, plus weight used for preferred shares multiplied by cost of preferred shares, plus weight used for common equity multiplied by cost of retained earnings.  (Eugene Brigham and Joel Houston; 1998, Fundamentals of Financial Management)  Thus, the formula for WACC is as follows:  WACC = wdkd(1-T)  +  wpskps  + wceks.
GE has issued only common shares thus far, so we can do away with the portion of the formula that is pertaining to preferred shares.  The following are balance sheet figures of GE derived from the financial statements for the year ended December 31, 2007, except the Total Market Value of Common Stocks:
Particulars (dollars in millions)
2007
Weights (%)
Total Short-Term Liabilities
246,113,000,000.00

Total Long-Term Liabilities
425,661,000,000.00

Total Liabilities/Debt
671,774,000,000.00
58
Total Market Value of Common Stocks
377,449,816,810.00

Retained Earnings
117,362,000,000.00

Total Common Equity
494,811,816,810.00
42
Source:  2007 GE Annual Report
With no preferred shares as of the year-end of 2007, the capital components of GE are just debt and common equity (common stocks plus retained earnings).
Authors Frank Reilly and Keith Brown in their book entitled, “Investment Analysis and Portfolio Management” have defined the Capital Asset Pricing Model or CAPM as a model that indicates what should be the expected or required rates of return on risky assets.  As such, it is a tool for valuing an asset by providing an appropriate discount rate to use in dividend valuation models.  CAPM is also one approach to estimating the cost of retained earnings.  (Eugene Brigham and Joel Houston; 1998, Fundamentals of Financial Management)  To use CAPM to estimate the cost of retained earnings, the following figures must be estimated:
The risk-free rate, kRF, as provided

3.80%
The stock’s beta coefficient, bi, to be used as an index of the stock’s risk. (source:  Yahoo!Finance)

0.44
The market risk premium, RPM, as provided

5.1%

Using the preceding values, we then come up with the CAPM equation:
ks = kRF          + (RPM) (bi)
    = 3.80%  + (5.10%)  (0.44)
    = 3.80% + 2.24%
    = 6.04%
To estimate GE’s cost of debt, its bond rating is needed.  Moody’s Investors Service has rated the GE bonds “AAA”.  In the light of its rating, the basis points that apply to GE are as follows:
Terms
Reuters Corporate Spreads for Industrials
Estimated Cost of
Debt
One (1) year or Short-Term

15 or 0.15%

2.31%
Ten (10) years or Long-Term, kd
55 or 0.55%
4.56%
Source:  Bondsonline Website

The cost of short-term debt is the sum of the shortest spread (0.15%) and the one-year yield on the Treasury Bond (2.16%). (Bankrate Website)  Then, the estimated cost of long-term debt is the sum of the 10-year spread (0.55%) and the 10-year yield on the Treasury Bond (4.01%).  (Bondsonline Website)

In the computation of the WACC, the estimated cost of the long-term debts will be used as the general cost of debt.  To compute the WACC using the CAPM, we come up with the following equations:
                                          WACC =         wdkd(1-T)         +  wpskps  +  wceks
                                                       = 0.58 (4.56%) (1-0.35)  +      0      + 0.42 (6.04%)
                                                     = 0.58 (4.56%) (0.65) + 2.54%
                                                     = 0.58 (2.96%) + 2.54%
                                                     = 1.72% + 2.54%
                                                      = 4.26%
Where:
         wd  and wce are the weights used for debt and common equity respectively.
         ks represents the cost of common equity from retained earnings, as computed above.
         kd represents the cost of long-term debt, as shown above
        The foregoing computation uses 35% as the effective tax rate, as provided in the    assumptions.

General Electric
Computations
Dec. 31, 2007 (in US$)
EBIT (Source:  Yahoo! Finance)

$50,385,000,000
Tax Rate

35.00%
(1-T)

65.00%
NOPAT = EBIT * (1-T)
$50,385,000,000 X 65%
$32,750,250,000
Capital (NWOC)

$115,559,000,000
EROIC (NOPAT/CAPITAL)
$32,750,250,000/$115,559,000,000
28.34%
WACC

4.26%
EROIC – WACC (positive)

24.08%
Market Value Added
377,449,816,810 – 699,000,000
376,750,816,810

2007
2006
2005
2004
2003
Sales (in millions)
172,738
151,843
136,580
124,176
104,624
Net Profit (in millions)
22,208
20,742
16,720
17,222
15,518
Total Equity (in millions)
115,559
111,509
108,633
110,181
78,873
Growth Rates (g)
13.8%
11.2%
10.0%
18.7%

Operating Profitability (OP)
12.9%
13.7%
12.2%
13.9%
14.8%
Capital Requirement (CR)
1.5%
1.4%
1.3%
1.1%
1.3%
Note:  All FS figures were taken from the 2007 GE Annual Report

Thus, GE’s cost of capital is generally way below its promised return on capital which is pegged at 20% in the near future.   GE has hitherto been a strong and financially sound giant, but investors and other stakeholders are yet to see the impact of the credit crisis on the company’s operations once the financial statements of the first half of 2008 are submitted and published by the GE management.

REFERENCE:
2007 GE Annual Report.  GE website. (http://www.ge.com/ar2007/index.jsp)
Brigham, E. and J. Houston.  Fundamentals of Financial Management. Orlando, Florida. The Dryden Press, 1998.
Reilly, F. and K. Brown. Investment Analysis and Portfolio Management. Orlando, Florida:  The Dryden Press, 1997.
Yahoo! Finance Website (http://finance.yahoo.com)
Moody’s Investors Service Website (http://www.moodys.com)
Bondsonline Group, Inc. (http://www.bondsonline.com); (http://classes.bus.oregonstate.edu/spring-07/ba440/Other%207%20handout%203.doc)
Bankrate Website (http://www.bankrate.com/brm/ratewatch/treasury.asp)

 

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