PROBLEMS Answers to odd-numbered problems appear at the end of the book. Answers

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PROBLEMS Answers to odd-numbered problems appear at the end of the book. Answers to even-numbered problems and additional exercises are available in the Instructor Resources within McGraw-Hill's Connect (see the Preface for more information). I. The Board of Directors of Collins Entertainment, Inc., has been pressuring its CEO to boost ROE. During a recent interview on CNBC, he announces his plan to improve the firm's financial performance. He will raise prices on all of the company's products by 10%. He justifies the plan by observing that ROE can be decomposed into the product of profit margin, asset turnover and financial leverage. By raising prices, he will increase the profit margin and thus ROE. Does this plan make sense to you? Why or why not? 2. a. Which company would you expect to have a higher price-to-earnings ratio: Alphabet or railroad company Union Pacific? Why? ratio: a financial institution or a high-technology company? Why? appliance manufacturer or a grocer? Why? elry store or an online bookstore? Why? b. Which company would you expect to have the higher debt-to-equity c. Which company would you expect to have a higher profit margin, an

Explanation / Answer

1 The plan of COE does not make sense, since the facts like impact of sales demand on account of increase in sales price , consideration of reducing production costs/fixed costs has not been analysised and also not condiered the following points Return on equity can be calculated by dividing the annual profit after tax of a company by its book value during that period. It tells you the rate of return the company is earning on the total funds that shareholders of the company have put in. The average ROE that a business earns over many years can tell you a lot about the profitability of the business. The maintenance of a strong ROE during good times and bad indicates a superior business model employed by the company, and can be a fabulous thing for the investors of the company provided that an exceptionally high price is not paid for buying a piece of that company. (a) Increasing sales turnover - Sales turnover is the ratio of sales to the total assets employed by the company. It indicates how efficiently the company is using its assets to generate sales. A company can try to perform better on this metric by decreasing the amount of assets it uses to achieve a certain level of sales. The major assets that can be attempted to be used more efficiently by a company are inventories, receivables and fixed assets. For example Company "X" - sales were about Rs 193 bn while its total assets at the end of FY were Rs 307 bn. Company's "X" sales turnover comes out to about 0.6 which is required to compare with general industry turnover. (b) Wider operating margins on sales - For every $ of sales that a company makes, there are many operating expenses that have to be met before it can arrive at its operating profits. Some of them are employee costs, raw material costs, and other general & administrative expenses. In times of inflation, companies are always on the lookout to try and increase the prices of their products without hurting demand. But the fact of the matter is that inflation causes an increase in its operating costs too. In such a situation, the only way a company can increase its margins and keep them wide is to increase its prices (sales) at a faster rate than the increase in its operating costs. This can be achieved only by way of some competitive advantage the company might posses like being the lowest cost producer, or having a strong brand that lets it raise prices without taking away from the demand for its products. More leverage - This is one thing a company might resort to if its ambitions to grow are higher than the pace of its internal accruals. Taking up more debt has the effect of enhancing the ROE of the company. But at the same time it exposes the company to certain external risks due to the fixed costs of the interest charged by the lender and the timely repayment obligations of the principal amount according to the preferences of the lender. Thus in general, a company earning a certain level ROE without any debt is much safer and superior than a company earning that same level of ROE by employing big amounts of debt. Taxes - Taxes can take a significant bite out of a company's profits and thus ROE. 2 (a) Alphabet is expected to have higher PE ratio compared to railroad union pacific, considerng the EPS (earning per share) of alphabet is higher compared to rail raod union pacific. (b) Financial instutions will have higher Debt-to-equity compared to high- technology company . - Financial instutions main activity is to borrow funds from public and lend to public/corporates, since the major activity of financial instutions is borrowing and lending, accordingly the debt will be higher and debt-to-equity ratio also will be higher. (C') Appliance manufacturer will have more profit margin compared to a grocer. Normally Appliance industry will have a gross margin of 30% to 35% and net margin of 7% to 10% whereas the profit margin of grocery shop ranges only from 1% to 3%. (D) Jewelry store will have higher current asset ratio compared to an online book store. - The investment (i.e current liabilities) in jewelery stores will be very high compared to online book store .

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