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Question 2. Industry effect on the strcuture of ROE (35%) Below are summarized balance sheets and...

Question 2. Industry effect on the strcuture of ROE (35%)

Below are summarized balance sheets and income statements of three US companies :

Income Statement (in millions)

Firm 1

Firm 2

Firm 3

Revenues

166.809

7.132

22.956

Earnings before interest and tax

10.105

1.419

10.937

Earning before tax

   9.083

1.114

14.275

Earnings after tax

   5.745

   714

9.421

Balance Sheet

Firm 1

Firm 2

Firm 3

Cash

1.856

     485

23.798

Accounts Receivable

1.341

     770

3.250

Inventories

19.793

     223

       0

Prepaid Expenses

1.366

     237

3.260

Net Fixed Assets

45.993

13.816

21.842

Total Assets

70.349

15.531

52.150

Short-term debt

5.408

     890

       0

Account payable

13.105

     616

1.083

Accrued Expenses

7.290

     158

8.672

Long-term liabilitites

18.712

8.205

1.027

Owner’s Equity

25.834

5.662

31.368

Total Liabilities and Owners’ equity

70.349

15.531

52.150

  1. Compute the working capital requirement of the three firms and prepare their managerial balance sheet
  2. Compute the three firms’ operating margin, invested capital turnover, return on capital employed, financial multiplier, and the tax effect, What is the relationship between these ratios and the firm’s ROE?
  3. One firm is in retail (nongrocery) industry, another is a utility firm, and the last one is in the software industry. Which of the companies correspondes to Firm 1, Firm 2, and Firm 3?

Solutions

Expert Solution

DISCCLAIMER :

Values as provided in the problem : as Balance sheet total of Firm-3 is not getting tallied by 10.00 and in Short term Debt section it was 0 so its assumed that it is 10 instead of 0 and remaining calculation are based on this assumption

Balance sheet Firm 1 Firm 2 Firm 3
Cash 1.856 0.485 23.798
Accounts Receivable 1.341 0.770 3.250
Inventories 19.793 0.223        0
Prepaid Expenses 1.366 0.237 3.260
Net Fixed Assets 45.993 13.816 21.842
Total Assets 70.349 15.531 52.150
Short-term debt 5.408 0.890 10.000
Account payable 13.105 0.616 1.083
Accrued Expenses 7.290 0.158 8.672
Long-term liabilitites 18.712 8.205 1.027
Owner’s Equity 25.834 5.662 31.368
Total Liabilities and Owners’ equity 70.349 15.531 52.150

1.

Working Capital Requirement Firm 1 Firm 2 Firm 3
Cuurent Asset
Accounts Receivable 1.341 0.77 3.25
Inventories 19.793 0.223        0
other Current Assets
Prepaid Expenses 1.366 0.237 3.26
(A) 22.5 1.23 6.51
Cuurent Liabilty
Account payable 13.105 0.616 1.083
Accrued Expenses 7.29 0.158 8.672
(B) 20.395 0.774 9.755
Working Capital (WCR) (A-B) 2.105 0.456 -3.245
managerial balance sheet Firm 1 Firm 2 Firm 3
Invested Capital
Cash 1.856 0.485 23.798
WCR 2.105 0.456 -3.245
Net Fixed Assets 45.993 13.816 21.842
Total Invested Capital 49.954 14.757 42.395
Capital Employed
Short-term debt 5.408 0.890 10.000
Long term Financing
Long-term liabilitites (LT) 18.712 8.205 1.027
Owner’s Equity (E) 25.834 5.662 31.368
Total Long Term Financing (LT + E) 44.546 13.867 32.395
Total Capital Employed 49.954 14.757 42.395
Net Long term Financing = (Long term liabillity - net Fixed Asset) -1.447 0.051 10.553
Net Short ter, Financing = Short term Debt -Cash 3.552 0.405 -13.798
Liquidity Ratio (net long term Financing/ WCR) -0.68741 0.111842 -3.25208

2.

Firm 1 Firm 2 Firm 3
Operating Margin 6.06% 19.90% 47.64%
Invested Capital Turnover (times) 3.34 0.48 0.54
return on capital employed 20.23% 9.62% 25.80%
Finance leverage Multiplier 1.738 2.046 1.764
Tax effect 63.25% 64.09% 66.00%
ROE 22.24% 12.61% 30.03%

Such Ratios help in better understanding of the financial of organzation like Firm 3 has high ROE with high Operating Margin while Firm 1 have lowest oprating profit margin but overall its giving good return on Equity

Working

Income Statement Firm 1 Firm 2 Firm 3
Revenues 166.81 7.132 22.956
Earnings before interest and tax (EBIT) 10.105 1.419 10.937
Earning before tax (EBT) 9.083 1.114 14.275
Tax (EBT-EAT) 3.338 0.400 4.854
Earnings after tax (EAT) 5.745 0.714 9.421
Operating Margin = (Revenue/ EBIT) * 100 6.06% 19.90% 47.64%
Total Invested Capital (TIC) 49.954 14.757 42.395
Invested Capital Turnover (times) = Revenue/Total invested Capital 3.34 0.48 0.54
Total Capital Employed 49.954 14.757 42.395
return on capital employed = (EBIT/ total Capital Employe) * 100 20.23% 9.62% 25.80%
Owner’s Equity 25.834 5.662 31.368
Pretax return on Equity = EBT/ Owners' Equity 35.16% 19.68% 45.51%
pre tax return on invested capital =EBIT/Invested capita 20.23% 9.62% 25.80%
Finance leverage Multiplier= (pretax return on Equity/ pretax return on invested capital) 1.738 2.046 1.764
Tax effect =(EAT/EBT) * 100 63.25% 64.09% 66.00%
Effective Tax rate = (1- tax effect) 36.75% 35.91% 34.00%
ROE = (EAT/ Owner's Equity) * 100 22.24% 12.61% 30.03%

3.

Firm 1 is retail (nongrocery) industry as it compete on price as evidenced by lower operating profit margin with high capital turnover ration in the group. Second in Pre-tax ROE is compesated by highest effective tax rate
Firm 2 is utility firm; with second highest in oprating margin and ROE with bottom in ROCE hence its has average perfomance in the group as belongs to uility industry.
Firm 3 is software industry as it has highest ROE (30.03%) this is beacuse of highest operating margin in the group. That could become possible as software has relatively high market share with less expensive to produce

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