Question

Operating return on assets (OROA) and free cash flow (FCF) are two performance measures. What are the similarities and the differences between these two performance measures.

Free Cash Flow (FCF) and Economic Value Added (EVA) are two performance measures. What are the similarities and differences between these two performance measures?

If a firm dramatically increases their R&D expense late in fiscal year 2018, what will be the impact of this decision on the firm's operating margin, EVA, and its stock price in 2018? Explain.

Answer 1

Ans1

Differences

Operating return on assets is used to show a company’s operating income that is generated per dollar invested specifically in its assets that are used in its everyday business operations while Free cash flow is the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base. It represents the cash that is available for all the investors of the company.

OROA is calculated by dividing Earnings Before Interest and Taxes by Average Total Assets

While Free Cash Flow is calculated by reducing investment made from Operating Profit after taxes.

Similarities

Both the ratios show the profit made as result of the investment.One showing in the form of per dollar investment made while the other showing the profit as a whole.

Also both the indicators are highter the better.

Ans.2

Differences

Free cash flow is the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base. It represents the cash that is available for all the investors of the company while Economic value added is the incremental difference in the rate of return over a company's cost of capital. In essence, it is the value generated from funds invested in a business

Free Cash Flow is calculated by reducing investment made from Operating Profit after taxes while EVA is calculated as below

(Net investment) x (Actual return on investment – Percentage cost of capital

Similarities

Both the indicators show the profitability which in turn helps the investors to take decisions.Both of them is calculated using Net operating Profit after taxes.

Ans3

Considering the R&D expenses are expensed out in P&L

1) Operating Margin will reduce

2)EVA will reduce as the rate of return will reduce

3)The share price may not necessarily go down as it is affected by a number of factors and not just the return on assets.