Chap 008 - RETURN ON INVESTED CAPITAL AND PROFITABILITY ANALYSIS

Chapter 08 Return on Invested Capital and Profitability Analysis

Chapter 08 - Return on Invested Capital and Profitability Analysis

Chapter 08

Return on Invested Capital and Profitability Analysis

Multiple Choice Questions

1.Which of the following ratios best measures the profitability of a company?A.Return on equityB.Gross marginC.Current ratioD.Net operating asset turnover

2.Below are the net operating asset turnovers and net operating profit margins for companies that operate in three different industries (A, B and C). The industries are grocery stores, oil extraction and drug industry.

Match the industry to A, B or CA.Choice AB.Choice BC.Choice CD.Choice D

3.Which of the following statements is correct?A.Net operating profit margin divided by net operating asset turnover equals return on net operating assetsB.Return on net operating assets can be disaggregated into net operating profit margin and leverageC.Return on equity equals return on net operating assets less interest, net of taxD.Return on equity can be disaggregated into net operating profit margin, net operating asset turnover and leverage

4.Which of the following could explain a decrease in net operating asset turnover for a company?A.Switching from straight line to accelerated depreciation for financial reporting purposesB.An increase in the financial leverage of the companyC.Addition of a new plant for production purposesD.Decrease cost of production inputs

5.Err Company has a major lawsuit against them for unsafe products. It recognizes a huge liability in 2004 of $300M. The effect of this liability is to decrease stockholders' equity by 50%. In 2005, the effect of recognizing this liability, all else equal, is:A.Return on net operating assets will increase dramaticallyB.Return on net operating assets will decrease dramaticallyC.Return on equity will increase dramaticallyD.Return on equity will decrease dramatically

6.Return on operating assets for 2005 is:A.7.9%B.7.41%C.8.78%D.8.1%

7.Return on common equity for 2005 is:A.11.42%B.10.0%C.11.0%D.10.47%

Assume all assets are operating assets; all current liabilities are operating liabilities.

8.Return on net operating assets for 2005 is:A.11.30%B.12.73%C.9.93%D.11.19%

9.Return on equity for 2005 is:A.20.41%B.19.75%C.17.54%D.18.12%

10.Which of the following could cause return on net operating assets to increase, all things other equal?A.A decrease in interest rate on debtB.Increase in days accounts receivable are outstandingC.Increase in inventory turnoverD.Decrease in gross margin

11.Eyster Corporation reported $10M in earnings and paid dividends of $3M for fiscal 2005.Return on equity and dividend payout are expected to remain constant for the foreseeable future. Net book value at the end of fiscal 2004 was 100M. Cost of equity is 10%. Using the residual income method, the intrinsic value of Eyster's stock at the end of 2005 should be:A.$110MB.$107MC.$100MD.not determinable

12.When calculating return on net operating assets, interest expense net of tax is added back to net income for purposes of calculating the numerator. What tax rate should be used?A.effective tax rateB.marginal tax rateC.statutory federal tax rateD.statutory federal tax rate plus statutory state tax rate

Below is selected information from Tricrop.

13.Return on Net Operating Assets for Year 1 is:A.30.8%B.16.3%C.15.4%D.14.5%

14.Return on Common Equity for Year 1 is:A.19.0%B.19.60%C.21.08%D.26.03%

15.Which of the following is correct concerning changes at Tricrop from Year 1 to Year 2? A.Choice AB.Choice BC.Choice CD.Choice D

16.Which of the following statements is correct concerning changes from year 1 to year 2 at Tricrop?A.Despite favorable changes in the tax rate return on net operating assets has decreasedB.Despite favorable changes in net operating asset utilization return on net operating assets has decreasedC.Largely because of favorable changes in tax rates return on net operating assets has increasedD.Largely due to favorable changes in leverage return on net operating assets has increased

17.Which of the following will increase the sustainable equity growth of a company, all other things equal?A.Increase dividend payoutB.Pay suppliers more quicklyC.Pay suppliers more slowlyD.Decrease dividend payout

18.An increase in net operating income (NOPAT) will cause which of the following?A.Increase in the return on net operating assetsB.Decrease in the return on net operating assetsC.No change in the return on net operating assetsD.The change in the return on net operating assets is unclear, there is not sufficient information

19.Which of the following would explain an observed decrease in return on equity, all else equal?A.Decrease in tax rateB.Increase in interest rate on debtC.Stock splitD.Stock dividend

20.Which of the following is the best measure of operating efficiency?A.Return on net operating assetsB.Return on equityC.Return on salesD.Return on inventory

21.Return on operating assets is a measure of which of the following?A.ProfitabilityB.EfficiencyC.SolvencyD.Liquidity

The following information relates to Yutter Corporation

22.What is Yutter's sustainable equity growth rate?A.9.12%B.9.88%C.11.4%D.12.0%

23.What is the value of Yutter's stock at the end of Year 1 using the dividend discount model assuming that the dividend payout ratio remains constant and Yutter grows at its sustainable equity growth rate?A.$83,333B.$157,642C.$500,000D.$557,000

24.If Yutter's dividend payout ratio increased to 50% after year 1 then:A.the sustainable equity growth rate would increaseB.the return on equity would increaseC.the value of the stock would decreaseD.the return on net operating assets would decrease

25.Cost of goods sold divided by inventory provides information about (choose one answer):A.profitabilityB.capital structureC.management of working capitalD.gross profit margin

26.When considering the difference between return on net operating assets (RNOA) and return on common shareholders' equity (ROCE), which of the following statements is incorrect?A.Preferred dividends are deducted from the numerator when calculating ROCE but not when calculating RNOAB.RNOA is a pre-interest measure but ROCE is notC.RNOA is a post-interest measure but ROCE is notD.RNOA is independent of the form of financing, but ROCE is not.

27.Purchases divided by accounts payable provides information about:A.capital structureB.management of working capitalC.gross profit marginD.profitability

WidgetCo and Tools Inc. both operate in the same industry. They are capital-intensive companies producing widgets. Below are selected data

28.Which of the following statements is the most plausible explanation of the difference in observed net operating profit margins?A.WidgetCo's lower financial leverageB.WidgetCo uses LIFO and Tools uses FIFOC.WidgetCo's lower tax rateD.WidgetCo's net operating asset turnover

29.Which of the following statements best explains the difference in observed net operating asset turnovers?A.WidgetCo's lower financial leverageB.WidgetCo uses FIFO and Tools uses LIFOC.WidgetCo's lower tax rateD.WidgetCo has significant operating leases and Tool has no leases

30.Which of the following statements is correct?A.Widget has higher RNOA than ToolsB.Widget has lower RNOA than ToolsC.Widget has same RNOA as ToolsD.Insufficient information to calculate RNOA

31.Which of the following statements could explain the difference in observed tax rates?A.Widget uses straight-line depreciation and Tool uses MACRSB.Widget uses LIFO and Tool uses FIFOC.Tool has foreign subsidiaries in countries with much lower tax ratesD.Widget has significant amounts of interest income from municipal bonds

32.Widget has a higher EBIT/Revenue but lower net operating profit margin than Tool. Which of the following statements could explain this? As a percentage of sales:A.Widget has greater interest expense and taxesB.Widget has greater interest expense but lower taxesC.Widget has lower interest expense but higher taxesD.Widget has lower interest expense and taxes

33.Which of the following statements about the relationship between RNOA and ROCE is correct?A.ROCE is always greater than RNOAB.ROCE is greater than RNOA if RNOA is greater than after-tax cost of dividendsC.ROCE is greater than RNOA if RNOA is greater than cost of debtD.ROCE is greater than RNOA if RNOA is greater than after-tax cost of debt

34.Which of the following statements about the equity growth rate is correct? I. the higher the ROCE the higher equity growth rate, all other things equalII. the higher the dividend payout the higher the equity growth rateIII. the equity growth rate is unaffected by the cost of debtIV. the equity growth rate indicates the expected growth in stock price each periodA.I, II, III and IVB.I, II and IIIC.I and IIID.I only

35.Which of the following statements about the return on shareholders' investment (ROSI) is correct?A.If book value of equity is less than market value, ROSI is greater than ROCEB.ROSI will be higher the greater the dividend payout ratioC.ROSI is likely to be more volatile than ROCED.ROSI normally equals ROCE

36.Which of the following situations is most likely to explain an accounts receivable turnover that is lower than the industry norm?A.The company makes less credit sales than industryB.The company gives customers less time to pay than its competitorsC.The company has been selling inferior products to competitorsD.The company is systematically over-estimating bad debts

37.Which of the following situations is most likely to explain a net operating asset turnover that is higher than the industry norm?A.The company has more recently purchased fixed assetsB.The company uses FIFO while competitors use LIFOC.The company uses accelerated depreciation method while competitors use straight lineD.The company extends more credit to customers than competitors

Selected information for Acme Corp.:

38.When calculating Acme's return on net operating assets in Year 1, which of the following adjustments to the asset base is most appropriate to consider?A.Accumulated depreciation adjustmentB.Intangible asset adjustmentC.Nonoperating asset adjustmentD.No asset adjustment



True / False Questions

41.An analysis of a company's performance requires joint analysis of net income in relation to the invested capital.TRUE

42.There is only one way to measure invested capital.FALSE

43.A company that operates in a highly competitive industry with low barriers to entry is likely to have low net operating profit margins compared to companies that operate in less competitive industries.TRUE

44.Companies that have low net operating profit margins generally only earn a reasonable return on net operating assets if they can utilize their net operating assets very efficiently.TRUE

45.The two components of RNOA, net operating profit margin and NOA turnover, are independent of each other.FALSE

46.If a company has rapidly growing earnings per share, their return on net operating assets must be increasing too.FALSE

47.When calculating return on equity minority interest is added to the numerator as it has been deducted in arriving at net income.FALSE

48.When calculating return on net operating assets, deferred taxes should be deducted from the denominator.FALSE

49.Return on equity is the return stockholders have received during the past year.FALSE

50.The relation between a company's return on common equity (ROCE) and return on net operating assets (RNOA) reveals information about the company's success with financial leverage.TRUE

51.A decrease in net operating profit margin will cause both return on net operating assets and return on equity to decrease, all other things being equal.TRUE

52.Return on net operating assets will always be greater than or equal to the pre-tax return on equity.FALSE

53.When calculating return on total equity it is normal to add back preferred dividends to net income.FALSE

54.It is possible to have an increasing return on net operating assets while net operating profit margin is decreasing.TRUE

55.Return on invested capital is a better measure of profitability than earnings as earnings numbers fail to reflect the capital needed to generate those earnings.TRUE

56.If two companies both increase their net income by 25% over the prior year this means they have both been equally profitable this year.FALSE

57.When calculating return on net operating assets it may be necessary to adjust assets to reflect the fact that not all assets are operating assets.TRUE

58.If future expected return on common stockholders' equity is less than expected required return by equity holders then the market value of a company's stock should be less than book value.TRUE

59.Sustainable equity growth rate is a function of return on common stockholders' equity and the dividend payout ratio.TRUE

60.Return on equity can be expressed as return on net operating assets multiplied by leverage (net operating assets/equity) and by earnings leverage.TRUE

61.The accounting-based stock valuation formula calculates the value of a stock as the book value of the net operating assets plus the present value of future expected dividends discounted at the cost of equity.FALSE

62.When calculating return on net operating assets, the numerator is net income plus minority interest.FALSE

63.Return on net operating assets is a better measure of operating performance than return on equity, as it is independent of the form of financing.TRUE

64.It is possible to have increasing earnings growth while having decreasing return on net operating assets.TRUE

65.It is possible to assess the common equity growth rate by analyzing the retention of earnings.TRUE

66.An advantage of leverage that benefits common stockholders is successful trading on the equity.TRUE

67.Financial statements of a diversified company should be analyzed by segments.TRUE

68.Practice considers a segment significant if its sales, operating income (or loss), or identifiable assets are 30% or more of the combined amounts of all the company's operating assets.FALSE

Essay Questions

69.Problem One: Return on Equity

a. Calculate return on common equity (ROCE) for fiscal X4 and X7. Identify, as far as allowed by the data, components driving any changes in ROCE from X4 to X7. (If you want to give students more guidance then ask to disaggregate ROCE into net operating profit margin, net operating asset turnover and leverage.)b. Compare and contrast the change in earnings per share to ROCE over this time period.

Problem One: Return on Equitya.

The ROCE has decreased. This is due in part to a decrease in net operating asset utilization and in part due to decreased net operating profit margin. The leverage has remained fairly constant.A common size income statement (see Appendix B) shows the decrease in net operating profit margin is driven in large part by the decrease in operating margin. This in turn is due to a decrease in gross margin, and an increase in operating, selling, general and administrative costs.The decreased net operating asset turnover is driven by decreased fixed asset turnover. All other net operating asset turnovers (except cash) have either increased or remained constant.b. Over the same time period net income has increase from $2,333 to $3,056 that is an increase of 9.2% per annum (compounded). The increase in income does not necessarily mean that the company is becoming more profitable. In this case the increase in net income is also associated with deteriorating gross margins, operating margins, net operating asset turnover and return on equity.

70.Problem Two: ROCE and EPS Calculation and Interpretation You are given the following data for Good Company Inc. for 2004, 2005, and 2006 (amountsin thousands).

a. Calculate ROCE for the three years.b. Calculate basic EPS for the three years.c. Interpret your findings for both ROCE and EPS.

Problem Two: ROCE and EPS Calculation and Interpretation

a. ROCE2004: $345 ( $735 = 46.9%2005: $402 ( $964 = 41.7%2006: $445 ( $1,231 = 36.1%b. Earnings per Common Share2004: $345 ( 132 = $2.612005: $402 ( 134 = $3.002006: $445 ( 135 = $3.30c. In general we find that ROCE decreases while EPS increases during the three-year period. The company issued additional shares of common stock during 2006, which increased average shareholders' equity more than it increased the number of common shares outstanding. Thus, we observe a decline in ROCE despite an increase in net income during the year. The net effect of increased earnings and the increased number of common shares outstanding is an increase in EPS.

71.Problem Three: Effect of Transactions Indicate the effect of the following transactions on:i.Return on net operating Assets (RNOA)ii. Return on common stockholders equity (ROCE)iii. Earnings per share (basic)Consider each transaction independently and explain your answer. Assume that ROCE is higher than RNOA.Company issues more preferred stock and uses proceeds to reduce accounts payable Company has a stock split Company converts to just-in-time inventory system (JIT). This allows them to hold half the levels of inventory for the same amount of sales (sales themselves are not increased by this change to JIT).

Problem Three: Effect of Transactions1. Company issues more preferred stock and uses proceeds to reduce accounts payablei. RNOA is unaffected as total assets do not change, and income from operations is unchangedii. ROCE will decrease. Net income is unchanged, but preferred dividends will increase thus decreasing the amount available for distribution to common stockholders. Common equity will also decrease but numerator effect will dominate normallyiii. Earnings per share will decrease as there is less earnings per common shareholder2. Company has a stock spliti. RNOA will be unchanged. All that has changed is that the number of shares outstanding ii. has increasedii. ROCE will be unchanged. See above.iii. Earnings per share will decrease as there are now more shares outstanding3. Company converts to just-in-time inventory system (JIT). This allows them to hold half the levels of inventory for the same amount of sales (sales themselves are not increased by this change to JIT). RNOA will be increased. The numerator will not be changed but net operating assets will decrease. (Note in reality operating income may well increase due to savings on insurance, storage costs, decreased obsolescence, etc.)i. ROCE will increase for reasons cited aboveii. Earnings per share will stay the same.

72.Problem Four: Financing Niglow Corporation produces metal castings. In the past year it earned a 10% return on its net operating assets base of $10M. Niglow needs $10M to expand its operations, and has the option of obtaining none, some, or all of the proceeds from the bank. Currently the company is all equity financed. It expects to be able to maintain its return on net operating assets after the expansion. The bank has indicated that the amount it will charge on the loan will be dependent upon the resultant debt/equity ratio. Specifically, the rates will be 8%, 9%, 10% and 12% for debt to equity ratios less than or equal to 0.25, 0.5, 1.0 and over 1.0, respectively. Niglow's tax rate is 40%.b. Calculate Niglow's return on common equity if the expansion is financed:i. using all equityii. 50% debt, 50% equityiii. all debtc. What would Niglow's return on net operating assets need to be for the return on equity to be decreased by financing the expansion using all debt.

Problem Four: Financinga. i. If the expansion is all equity financed then ROCE will equal RNOA of 10%ii.50% debt and 50% equity means a resultant debt to equity ratio of 1/3 (5/10+5). This will result in an interest rate of 9%. Interest costs will be 5Mx.09 = .45M. After tax the interest costs will be .45*(1-.4) = 0.27M. RNOA equals 10% which means net income before interest, net of tax is 20Mx.10 = 2M. Therefore net income will be 2M- 0.27M = 1.73M. ROCE will be 11.53%iii. All debt financed will result in a debt/equity ratio of 1. This will mean an interest rate of 10%. Interest costs will be 10Mx .1 = 1M. After tax, this will be 0.6M. Therefore, net income will be 2M -0.6M = 1.4M. ROCE will be 14%.b. If return on equity is decreased by using all debt this means that the after tax cost of debt would be higher than return on net operating assets. An all debt financed expansion has an after tax cost of 6% (10 x (1-.4)). Therefore, if return on net operating assets was less than 6% this would result in a decrease in the return on equityAssume return on net operating assets is 6%, this implies NOPAT of 1.2M after expansion. All debt financed will result in a debt/equity ratio of 1. This will mean an interest rate of 10%. Interest costs will be 10Mx .1 = 1M. After tax, this will be 0.6M. Therefore, net income will be 1.2M -0.6M = 6M. ROCE will be 6%. Thus if RNOA is 6% and after-tax cost of debt is 6%, the RNOA remains the same. If it is less than 6%, ROCE decreases.

73.Problem Five: Ratios Below are selected ratios for Manufacturers Corporation. Use this information answer thefollowing questions.

a. Calculate return on net operating assets for all three years. Identify reasons for any changes.b. Calculate return on equity for all three years. Comment on changes.

Problem Five: Ratios

a. RNOA has declined in year 2 and year 3. The decline is due mostly to decreased net operating asset utilization. That is, the amount of net operating assets needed to support sales has increased disproportionately. This appears to be driven by the inventory levels, as inventory turnover has decreased significantly. The net operating profit margin dropped in year 2, apparently due to decrease in gross margin. There is no further deterioration in year 3 in operating margin. It would appear inventory management should be investigated further.b. ROCE has declined in year 2 and in year 3. The decline is due in part to decreased leverage and in part due to decreased net operating asset utilization (see above).

74.Problem Six: Return on Net Operating Assets When calculating return on net operating assets analysts sometimes make adjustments to the net operating asset base used in the denominator or the ratio. Three possible adjustments are listed below. Explain what these adjustments are, and discuss the merits of these adjustments.Nonoperating asset adjustment. Intangible asset adjustment. Accumulated depreciation adjustment

Problem Six: Return on Net Operating Assets

1. Nonoperating asset adjustment. Non-operating assets such as investments in marketable securities and excess cash (or equivalents) are deducted from invested capital. The objective is to focus the analysis on net operating assets and operating results separate from the financial activities of the company. Of course, if net operating assets are taken out of the denominator, the related investment income (interest, dividends and gains/losses) must be taken out of the numerator. It may be appropriate not to exclude certain investments in entities that are closely tied to operating performance. Removal of non-operating assets can be a useful refinement of the standard analyses for companies with significant investments in financial assets.2. Intangible asset adjustment. This adjustment deducts intangible assets from invested capital. This adjustment is made because of skepticism regarding their value. Under current GAAP, intangible assets are periodically reviewed for impairment and written down if necessary. Therefore, further adjustment of their value should only be made if information so indicates. Exclusion of all intangible assets from invested capital is not appropriate. They represent valid investments by the company and management is responsible for assuring a reasonable return on all assets.3. Accumulated depreciation adjustment. This adjustment adds back accumulated depreciation on depreciable assets to the balance sheet. No adjustment is made to net income for depreciation expense. The rationale is that without this adjustment return on investments will continually rise as the assets get older (net assets decreases). The argument is that if assets are kept in prime working order this adjustment is needed to stop this distortion. If a company is continually replacing P, P&E this adjustment is not really valid. Furthermore, maintenance and repair expenses tend to rise as machinery and equipment age. These rising costs would therefore reduce the return on the older assets.

75.Problem Seven: Factors Affecting Return on Capital You are comparing the Return on Common Equity (ROCE) and its components (net operating profit margin, net operating asset turnover and leverage) of two companies in the same industry, ABC Corp and XYZ Corporation. Explain how each of the following will affect of ROCE and its components of ABC relative to XYZ, all other things equal.1 ABC Corporation is 100% equity financed, whereas XYZ has a significant amount of debt financing.2 ABC issued stock dividend during year, and XYZ did not.ABC uses FIFO and XYZ uses LIFO (assuming normal economic conditions) ABC sold receivables at face value at the end of the year.

Problem Seven: Factors Affecting Return on Capital

76.Problem Eight: ROCE and Components Below are selected ratios for Widget Corporation and Tools Inc. Use this information answer the following questions.

a. We know from the residual income method of valuation that, all other things equal, the company with the higher ROCE will have a higher intrinsic value.b. Why are all other things not likely to be equal in this instance (hint: look at components of ROCE)?c. Which company has better operating performance (that is, ignoring capital structure).

Problem Eight: ROCE and Components

a. Tools Inc. has the higher ROCEb. Tools Inc appears to be much more highly leveraged than Widget Corporation. The more leverage a company has the higher the required return by the equity holders (cost of equity capital). The value of a company is dependant upon the amount by which a company can earn above its cost of capital. Therefore, just because Tools has a higher ROCE does not mean that it is necessarily creating more value for its shareholders.c. Widget Corp. has a higher RNOA than Tools. RNOA is independent of capital structure and therefore is a good measure of operating performance.

8-1

Chap 008 - RETURN ON INVESTED CAPITAL AND PROFITABILITY ANALYSIS

Documents