Question

Sports Suply Sdn Bhd is a company that manufacture sport shoes such as running shoes, training shoes and football shoes in mass production. The company has decided to invest in a new cutting machine to meet its projected growth in demand next year. The management has asked you to provide them with the necessary information regarding the acquisitions of the new machine.

Currently their net operating profit after tax (NOPAT) is RM 2,500,000 and the average net operating asset is RM 8,850,000. Turnover for the year is RM 3,950,000 and the tax rate is 20%.

The company has planned to purchase the latest technology of cutting machine costing RM 2,000,000. The company has three alternatives to raise capital for this purpose.

Alternative 1: Issue RM 2,000,000 ordinary shares with par value RM1.

Alternative 2: Issue a 6% bonds with maturity period 10 years for RM 1,000,000 and RM 1,000,000 ordinary share with par value RM1.

Alternative 3: Issue a 6% bonds with maturity period 10 years for RM 700,000 and 6% convertible preference shares for RM 1,300,000.

Required:

1. Construct an extract Statement of Profit or Loss by showing its Net Profit Before tax (NPBT), Net Income, and net Income Available to Common Shareholders for each of the alternative.
2. Construct an extract Statement of Financial Position by showing its assets, equities and liabilities for each of the alternative.
3. Compute the Return on Net Operating Asset (RNOA) after acquisition of the company.
4. i)Describe Return on Common Equity (ROCE)
5. 2. Compute the ROCE for the company.

5. Disaggregate the company’s ROCE into profit margin, asset turnover, and leverage component for each of the alternatives.

6. Suggest the best alternative for the company. Justify your answer.
7. Briefly explain the uses of Return on Invested Capital (ROIC).

Answer 1

1.Statement of Profit or Loss
	Alt.-1	Alt.-2	Alt.-3
Net Profit Before Interest & tax (NPBIT)(2500000/(1-20%)*100%)	3125000	3125000	3125000
Interest expense(1000000*6%) & (700000*6%)		-60000	-42000
NPBT	3125000	3065000	3083000
Tax at 20%	-625000	-613000	-616600
Net Income	2500000	2452000	2466400
Preference dividends(1300000*6%)			-78000
Income Available to Common Shareholders	2500000	2452000	2388400

2.Statement of Financial Position
	Current	Alt.-1	Alt.-2	Alt.-3
Assets
Av.Net operating assets:
Before acquisition	8850000	8850000	8850000	8850000
Cutting machine		2000000	2000000	2000000
Cash (for interest expense60000*(1-20%)& 42000*(1-20%)			-48000	-33600
NOA after acquisition	8850000	10850000	10802000	10816400
Liabilities & equity
Non-current Liabilities
6% bonds			1000000	700000
Equity
Preference shares				1300000
Common equity -Before acquisition	6350000	6350000	6350000	6350000
-new		2000000	1000000
Retained Earnings-Before acquisition	2500000
-after acquisition		2500000	2452000	2466400
Total SH Equity	8850000	10850000	10802000	10816400

3.Return on Net opg. Assets(RNOA)
Net Income/Av.net opg. Assets
1.Net Income		2500000	2452000	2466400
2.Av.NOA after acquisition		10850000	10802000	10816400
So, RNOA(1/2)=		23.04%	22.70%	22.80%

4.i) Return on Common Equity (ROCE)=Net Income/Av. Common Equity (%)

here,it is $ net income by the company, per $ 100 of total common equity invested.

4.ii.Return on Common equity
Net Income for the period/Av. Common equity
1.Net Income		2500000	2452000	2466400
2.Common equity(existing+new)		8350000	7350000	6350000
ROCE=(1/2)		29.94%	33.36%	38.84%

5..ROCE--- disaggregated into:
Profit margin(PM)=Net Income to equity/Sales
1.Net Income		2500000	2452000	2466400
2. Sales		3950000	3950000	3950000
PM=(1/2)		63.29%	62.08%	62.44%
Asset Turnover(ATO)=Sales/Av. Total (here opg.)assets
1.Sales		3950000	3950000	3950000
2.Av.NOA after acquisition		10850000	10802000	10816400
ATO=(1/2)		36.41%	36.57%	36.52%
Leverage(FL)=Av. NOA/Av. Common equity
1.Av.NOA after acquisition		10850000	10802000	10816400
2.Common equity(existing +new)		8350000	7350000	6350000
FV=(1/2)		1.30	1.47	1.70
PM*ATO*FL=		29.94%	33.36%	38.84%

6.Alternative -3   seems to be the best alternative

Alternative 3: Issue a 6% bonds with maturity period 10 years for RM 700,000 and 6% convertible preference shares for RM 1,300,000.

as it has the greatest ROCE of 38.84%% amongst the alternatives.

As per the Du-Pont analysis, ROCE is greater in Alt-3 because of the leverage --debt being included ---also gives tax advantages of the interest expense

7.Uses of Return on Invested Capital (ROIC)

ROIC is the total capital invested, that is debt +Preference capiatl +equity

ie. Total assets-current liabilities

so, it helps to assess the efficiency of the usage of the long-term funds, in generating profits from core operations, the purpose for which the business was formed.

Gives an , even-more broader idea than operating /working capital