In: Finance
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
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 | ||||||||||