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

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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
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

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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%

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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 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

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

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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

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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
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%

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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

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

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Chapter 08 - Return on Invested Capital and Profitability Analysis

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 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

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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

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

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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

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.:

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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?
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

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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

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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

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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

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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

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69. Problem One: Return on Equity

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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
associated with deteriorating gross margins, operating margins, net operating asset turnover
and return on equity.

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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 EPS.

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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 Transactions
1. Company issues more preferred stock and uses proceeds to reduce accounts payable
i. RNOA is unaffected as total assets do not change, and income from operations is unchanged
ii. 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 normally
iii. Earnings per share will decrease as there is less earnings per common shareholder
2. Company has a stock split
i. RNOA will be unchanged. All that has changed is that the number of shares outstanding ii.
has increased
ii. ROCE will be unchanged. See above.
iii. Earnings per share will decrease as there are now more shares outstanding
3. 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 above
ii. Earnings per share will stay the same.

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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 equity
ii. 50% debt, 50% equity
iii. all debt
c. 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: Financing
a. 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 equity
Assume 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.

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73. Problem Five: Ratios

Below are selected ratios for Manufacturers Corporation. Use this information answer the
following 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).

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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.

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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

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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 ROCE

b. 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.

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