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What are the formulas for ROI and what is the purpose? Which type of SBU is this best used with? What are some limitations?
- To determine the efficiency; use with Investment SBU
- (1) net income / investment capital, where investment capital = equity securities + bonds + loans + capital leases OR assets used for production
- (2) (net income / sales) x (sales / invested capital) which nets to the same (1) equation
- Limitations: (1) doesn't take into account the timeframe. Make certain you are comparing ROIs over the same period of time. (2) Encourages managers to use a short-term focus. May delay investment in new assets now that will harm revenues later.
What are the formulas for ROA? What is it used for? What are some limitations to ROA?
- (1) Net income / avg assets, where avg assets are (balance at end of previous year + balance at end of current year) / 2
- (2) Net profit margin x asset turnover
- Use: measures profitability
- Limitations: assets can be valued many different ways (1) book value, (2) replacement value, (3) liquidation value, etc
What are the formulas for Return on Equity? What is its benefit?
- (1) Net income / avg equity
- (2) DuPont ROE
- (3) Extended DuPont ROE
- It's very easy to calculate. It's best used as a comparative measures (such as this period to prior period, or this period to an industry standard).
What is the (1) basic, and (2) modified formula for the non-extended Dupont Analysis
- A 3-step process to determine Return on Equity.
- (1) Net profit margin = net income / sales. A measure of operating efficiency
- (2) Asset turnover = sales / avg assets. A measure of efficiency regarding use of assets.
- (3) Financial leverage = avg assets / avg equity. A measure of how much of each asset do the shareholder's own (the balance would go to creditors)
- (1) x (2) x (3) = net income / equity
- OR ROA x financial leverage = ROE
What is the formula for the Tax Burden?
Net Income / Pre-tax Income
What is the formula for Interest Burden? What is another name for this formula?
- Pretax Income / EBIT
- Interest Coverage Ratio
What is the formula for the EBIT Margin? What is another name for the EBIT Margin?
- EBIT / Sales
- Operating Income (or Profit) Margin
What is the extended DuPont formula?
tax burden x interest burden x EBIT margin x asset turnover x financial leverage = ROE or net income / equity
What is the formula for Residual Income? How is this different from ROI? What are the uses, benefits and limitations?
- Net income - required return, where required return = equity x hurdle rate
- Equity = aka net book value
- Interpretation: is there any money left after the investors get the return they expect.
- ROI is a %, while Residual Income is a dollar value.
- Benefits: (1) Places an actual dollar value to the expected return on investment. (2) Encourages managers to invest in projects that will beat the hurdle rate.
- Limitations: (1) Difficult to makes comparisons between SBUs. Larger business units will generate larger amounts of revenue and net income thus making it easier to hit the target amt. (2) determining a target rate of return can be subjective
What is the purpose of economic value added calculations?
- This is a variation of profit. Profit doesn't consider there is a "cost" to capital.
- Interpretation: is there any money left after the investors get the return they expect, and if so, how much?
- We want to measure the return compared to the "cost" of the capital needed to generate that return.
- To determine performance in comparison to changes with all capital (debt and equity).
What is the formula for economic value added (EVA)?
net operating profit after taxes (NOPAT)[but not counting interest expense] - required return, where required return = (invested capital x WACC) or [(total assets - current liabilities) x WACC]
Which of the following results in the largest vs smallest ROA? (1) net book value, (2) gross book value, (3) replacement cost, (4) liquidation value
- Net book value provides the largest ROA because it's the smallest amount used in the denominator
- Replacement cost results in the smallest ROA because it has the greatest amount used in the denominator
True / False: When determining EVA, a company can adjust the NOPAT amount using different non-GAAP factors so long as it uses the same comparative amount year-to-year
- True. GAAP is not a factor for internal accounting. Some common adjustments include...
- capitalizing R&D (must also adjust NOPAT to remove R&D expense)
- using current asset value rather than book value
- ignoring deferred taxes
If debt = 40% of the assets, how much is the equity?
The basic objective of the residual income approach is to have a division maximize its (1) cash flows in excess of a desired minimum amt, (2) inputed interest rate charge, (3) income in excess of a desired minimum amount, (4) return on investment rate
(3) income in excess of a desired minimum amount
Gross Margin is a measure of (1) leverage, (2) profitability, (3) solvency, (4) liquidity
Which of the following denominators is criticized for combining the effects of operating decisions made at one level of the organization with financing decisions made at another level? (1) total assets employed, (2) total assets available, (3) working capital plus other assets, (4) shareholder's equity
(4) shareholder's equity