BEC 3 Asset Effectiveness and Efficiency

Question 1

Define Return On Investment (ROI)

Answer 1

Return on investment is used to assess the percentage return relative to capital investment risk. ROI can be calculated as income divided by invested capital or as a product of profit margin (income / sales) and investment turnover (sales / assets)

Question 2

What is the limitation on ROI?

Answer 2

1. ST Focus

2. Disincentive to invest

Question 3

Define return on equity (ROE)

Answer 3

ROE is a measure of the rate of return earned by a company on the equity component of its capital structure. It shows how well a company is using its funds to generate earnings.

Question 4

What is the equation for the DuPont ROE?

Answer 4

DuPont ROE = Net profit margin x Asset Turnover x Financial Leverage

where:
1. Net Profit Margin = Net Income / Sales
2. Asset T/O = Sales / Average total assets
3. Financial leverage = Average total assets / Equity

Question 5

What is the equation for the extended DuPont ROE?

Answer 5

Extended DuPont ROE = Tax burden x Interest burden x Operating income margin x Financial leverage

Where:

1. Tax burden = NI / Pretax income
2. Interest burden = Pretax income / EBIT
3. Operating income margin = EBIT / Sales
4. Asset TO = Sales / Average total Assets
5. Financial leverage = Average total assets / Equity

Question 6

Define residual income.

Answer 6

The residual income method measures the excess of actual income earned by an investment over the hurdle rate.

Question 7

What is the formula for residual income?

Answer 7

Residual Income = NI - Required return

Where the required return is equal to:
Net book value x hurdle rate = required return

If the amount of the income from the investment exceeds the computed required return, performance objectives have been met.

Question 8

Define economic value added (EVA). How does EVA differ from residual income?

Answer 8

EVA measures the excess of income after taxes earned by an investment over the rate of return defined by the company’s WACC. EVA differs from residual income in the following ways:

1. WACC must be used to calculated EVA
2. The income and investment numbers used to calculate EVA are generally adjusted to produce a more accurate analysis of economic profit.

Question 9

Define the steps and formula for economic value added.

Answer 9

Step 1: Calculate the required amount of return and income after taxes

Investment x Cost of capital = Required return

Step 2. Compare income to the required return

Income after taxes - required return = EVA