CH 3, Module 5

Question 1

Return on investment

Answer 1

percentage of return relative to its capital investment risk

= income / investment capital
Where investment capital is debt + equity

OR

= Profit margin x investment turnover

OR

= (income/sales) x (sales/invested capital)

Question 2

Return on assets

Answer 2

net income / average total assets

Question 3

ROI/ROA issues

Answer 3

variations on asset valuation (i.e. net book value, gross book value which deducts out depreciation, replacement cost or liquidation value) - company should be consistent each period!

Question 4

limitations of ROI

Answer 4

its a measure of %, not a measure of $

short term focus - use of ROI exclusinvely can inadvertendly focus managers purely on maximizing short term returns

disincentive to invest - profitable units are reluctant to invest in additional productive resources because they could reduce ROI in the short term

Question 5

return on equity

Answer 5

net income / equity

measure of a company’s effectiveness

Question 6

net profit margin

Answer 6

net income / sales

measure of operating efficiency

Question 7

Asset turnover

Answer 7

sales / assets

Measure of degree of efficiency in which a company uses its assets

Question 8

Financial leverage

Answer 8

assets / equity

exten to which a company uses debt in its capital structure

Question 9

dupont analysis - ROE

Answer 9

ROE = Net profit margin x asset turnover x financial leverage

Question 10

depont analysis - ROA

Answer 10

net profit margin x asset turnover

Question 11

Net profit margin broken down

Answer 11

tax burden x interest burden x operating income margin

Question 12

tax burden

Answer 12

net income / pretax income

extent to which a company retains profits after paying taxes

Question 13

interest burden

Answer 13

pretax income / EBIT

how much in pretax income a co retains after paying interest to debt holders

Question 14

EBIT margin

Answer 14

operating income margin

EBIT / SAles

measure of company profits earned on sales after paying operating and nonoparting costs (other than interest and taxes)

Question 15

residual income

Answer 15

measures the excess of actual income earned by an investment over the return required by the company (return in $).

rate of return for the company may be its WACC, cost of equity, or something else

= NI - required return
where require return = NBV of equity x decided hurdle rate

positive is good!

Question 16

benefits of residual income performance measures

Answer 16

encourages managers to invest in projects that generate income in excess of the target or calculated rate

Question 17

weaknesses of resiudal income as performance measure

Answer 17

reduced comparability

larger units of an org may produce larger dollar volumes of residual income even through their performance is identical to a smaller unit on a percentage basis

Question 18

economic value added

Answer 18

method performance evaluation is very similar to the residual income method

EVA measure the excess of income after taxes (not counting interest expense) earned by an investment over the return rate define by the company’s overall cost of capital (WACC)

= Net operating profit after taxes - required return
where required return = investment X WACC (always)

Positive is good!