Question

In: Finance

Profit margin is 10%, asset turnover is 1.5 times, financial leverage is 2.0 times, earnings per...

Profit margin is 10%, asset turnover is 1.5 times, financial leverage is 2.0 times, earnings per share are $2.00 and dividends per share are $2.50. Which of the following statements is correct:

1. The return on assets is greater than the return on equity

            2. The return on equity is greater than the sustainable growth rate

            3. The sustainable growth rate is greater than the return on assets

            4. The stock is over valued

Solutions

Expert Solution

We would calculate return on assets, return on equity and sustainable growth rate to determine which statement is correct
Return on assets Profit margin*Asset turnover
Return on assets 10%*1.5
Return on assets 15.00%
Return on equity Profit margin*Asset turnover*Financial leverage
Return on equity 10%*1.5*2
Return on equity 30.00%
Sustainable growth rate Retention ratio*Return on equity
Retention ratio 1-Payout ratio
Retention ratio 1-(2.50/2)
Retention ratio 1-1.25
Retention ratio -25.00%
Sustainable growth rate -25%*30%
Sustainable growth rate -7.5%
Statement (1) and (2) are incorrect as return on assets is lower than return on equity and sustainable growth rate is lower than return on assets
Return on equity is greater than sustainable growth rate and thus statement (2) is correct
Thus, statement (2) is correct

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