Chapter 8 Return on Invested Capital and Profitability Analysis PDF

Preview

Summary

Chapter 08Return on Invested Capital and Profitability AnalysisMultiple Choice Questions Which of the following ratios best measures the profitability of a company? A. Return on equity B. Gross margin C. Current ratio D. Net operating asset turnover Below are the net operating asset turnovers and ne...

Description

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 equity B. Gross margin C. Current ratio D. 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 C

A. Choice A B. Choice B C. Choice C D. 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 assets B. Return on net operating assets can be disaggregated into net operating profit margin and leverage C. Return on equity equals return on net operating assets less interest, net of tax

8-1

Chapter 08 - Return on Invested Capital and Profitability Analysis

D. 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 purposes B. An increase in the financial leverage of the company C. Addition of a new plant for production purposes D. 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 dramatically B. Return on net operating assets will decrease dramatically C. Return on equity will increase dramatically D. Return on equity will decrease dramatically

6. Return on operating assets for 2005 is: A. 7.9% B. 7.41%

8-2

Chapter 08 - Return on Invested Capital and Profitability Analysis

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% 8-3

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 debt B. Increase in days accounts receivable are outstanding C. Increase in inventory turnover D. 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. $110M B. $107M C. $100M D. 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 rate B. marginal tax rate C. statutory federal tax rate D. statutory federal tax rate plus statutory state tax rate

Below is selected information from Tricrop.

8-4

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 A B. Choice B C. Choice C D. Choice D

8-5

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 decreased B. Despite favorable changes in net operating asset utilization return on net operating assets has decreased C. Largely because of favorable changes in tax rates return on net operating assets has increased D. 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 payout B. Pay suppliers more quickly C. Pay suppliers more slowly D. 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 assets B. Decrease in the return on net operating assets C. No change in the return on net operating assets D. 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 rate B. Increase in interest rate on debt C. Stock split D. Stock dividend

20. Which of the following is the best measure of operating efficiency? A. Return on net operating assets B. Return on equity C. Return on sales

8-6

Chapter 08 - Return on Invested Capital and Profitability Analysis

D. Return on inventory

21. Return on operating assets is a measure of which of the following? A. Profitability B. Efficiency C. Solvency D. 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. $83,333 B. $157,642 C. $500,000 D. $557,000

8-7

Chapter 08 - Return on Invested Capital and Profitability Analysis

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

25. Cost of goods sold divided by inventory provides information about (choose one answer): A. profitability B. capital structure C. management of working capital D. 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 RNOA B. RNOA is a pre-interest measure but ROCE is not C. RNOA is a post-interest measure but ROCE is not D. RNOA is independent of the form of financing, but ROCE is not.

27. Purchases divided by accounts payable provides information about: A. capital structure B. management of working capital C. gross profit margin D. profitability

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

8-8

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 leverage B. WidgetCo uses LIFO and Tools uses FIFO C. WidgetCo's lower tax rate D. 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 leverage B. WidgetCo uses FIFO and Tools uses LIFO C. WidgetCo's lower tax rate D. WidgetCo has significant operating leases and Tool has no leases

30. Which of the following statements is correct? A. Widget has higher RNOA than Tools B. Widget has lower RNOA than Tools C. Widget has same RNOA as Tools D. 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 MACRS B. Widget uses LIFO and Tool uses FIFO C. Tool has foreign subsidiaries in countries with much lower tax rates D. Widget has significant amounts of interest income from municipal bonds

8-9

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 taxes B. Widget has greater interest expense but lower taxes C. Widget has lower interest expense but higher taxes D. 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 RNOA B. ROCE is greater than RNOA if RNOA is greater than after-tax cost of dividends C. ROCE is greater than RNOA if RNOA is greater than cost of debt D. 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 equal II. the higher the dividend payout the higher the equity growth rate III. the equity growth rate is unaffected by the cost of debt IV. the equity growth rate indicates the expected growth in stock price each period A. I, II, III and IV B. I, II and III C. I and III D. 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 ROCE B. ROSI will be higher the greater the dividend payout ratio C. ROSI is likely to be more volatile than ROCE D. ROSI normally equals ROCE

8-10

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 industry B. The company gives customers less time to pay than its competitors C. The company has been selling inferior products to competitors D. 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 assets B. The company uses FIFO while competitors use LIFO C. The company uses accelerated depreciation method while competitors use straight line D. 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 adjustment B. Intangible asset adjustment C. Nonoperating asset adjustment D. No asset adjustment

39. When calculating Acme's return on net operating assets in Year 2, which of the following adjustments to the asset base is most appropriate to consider?

8-11

Chapter 08 - Return on Invested Capital and Profitability Analysis

A. Accumulated depreciation adjustment B. Intangible asset adjustment C. Nonoperating asset adjustment D. No asset adjustment

40. When calculating Acme's return on net operating assets in Year 3, which of the following adjustments to the asset base is most appropriate to consider? A. Accumulated depreciation adjustment B. Intangible asset adjustment C. Nonoperating asset adjustment D. 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.

8-12

Chapter 08 - Return on Invested Capital and Profitability Analysis

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.

8-13

Chapter 08 - Return on Invested Capital and Profitability Analysis

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

8-14

Chapter 08 - Return on Invested Capital and Profitability Analysis

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.

8-15

Chapter 08 - Return on Invested Capital and Profitability Analysis

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

8-16

Chapter 08 - Return on Invested Capital and Profitability Analysis

8-17

Chapter 08 - Return on Invested Capital and Profitability Analysis

8-18

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 Equity a.

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

8-19

Chapter 08 - Return on Invested Capital and Profitability Analysis

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 (amounts in 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. ROCE 2004: $345  $735 = 46.9% 2005: $402  $964 = 41.7% 2006: $445  $1,231 = 36.1% b. Earnings per Common Share 2004: $345  132 = $2.61 2005: $402  134 = $3.00 2006: $445  135 = $3.30 c. 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 E...