In: Finance
Q1: ROE, ROA, ROIC are given for Company A and Company B (unrelated to Flash Memory). | ||||||
Company A | Company B | |||||
Interest rate | 6.0% | 8.0% | ||||
Income tax rate | 17.0% | 17.0% | ||||
Debt | 585 | 100 | ||||
Equity | 348 | 833 | ||||
TOTAL LIAB+EQUITY | 933 | 933 | ||||
EBIT | 86 | 86 | ||||
- Interest expense | 35.1 | 8 | ||||
Earnings before tax | 50.9 | 78 | ||||
- Income tax | 8.7 | 13.3 | ||||
Earnings after tax | 42.2 | 64.7 | ||||
Ratio | Fraction | Ratio | Fraction | Numerator | Denominator | |
RETURN ON EQUITY (ROE) | 12.1% | 42.2/348 | 7.8% | 64.7/833 | Earnings after tax | Equity |
RETURN ON ASSETS (ROA) | 4.5% | 42.2/933 | 6.9% | 64.7/933 | Earnings after tax | Total Liab+Equity |
RETURN ON INVESTED CAPITAL (ROIC) | 7.7% | 86*.83/933 | 7.7% | 86*.83/933 | EBIT * (1-Tax rate) | Total Liab+Equity |
1a: Why is Company A ROE higher than Company B ROE? Is it better? Why? Why not? |
1b: Why is Company A ROA lower than Company B ROA? What does it tell you about the two companies? |
1c: How do the Company A & Company B ROICs compare? What does this suggest about the two companies? |
1.a) The RoE of Company A is higher than company B because the amount of equity in the company A is lower than that in Company B. Since RoE is only concerned with Net income and equity it does not take into account the bankruptcy cost which are associated with having a large amount of debt on the Company balance sheet. Therefore, although the RoE of the company A is higher, it is not necessary good as the Company A is a lar amount of Debt which needs to be serviced regularly. As can be seen, the interest amount Company A pays is much larger than Company B. Therefore, care should be taken while interpreting RoE. Since, Company A is riskier, equity investors demand a higher return, hence RoE of Company A is high.
1.b) Since both companies have an equal asset base of 933, RoA shows which company is better at generating returns from the assets deployed. Clearly, Company B is better at converting assets in net income as it generated 64.7 units of net income as against 42.2 units of net income in Company A. Thus, it shows that Company B utilizes its assets better than Company A, eben though Company A has a higher RoE, Company B is more efficient overall.
1.c) ROIC is equal for both companies. it shows that the both the companies generate same amount of net operating income returns. Taking 1.a and 1.b into account, it can be said that the difference in returns of RoE and RoA is only due to the capital structure of the companies.