Reconciling RNOA with ROCE by XNWk4d6R

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                               Reconciling RNOA with ROCE
                                               Suggested Solution

data:
                                                      97                  96
                Operating Assets                    3,000               2,600
                Operating Liabilities               (1,100)             (1,000)
                Debt (Interest bearing)             (1,400)             (1,200)
                Common Shareholders=                  500                 400
                Equity


                Operating Earnings (BT)              224
                Financial Expense (BT)               (104)
                Tax Expense                           (30)
                Net Earnings                           90

The statutory tax rate equals 35%.



Part A
(i)     Determine the effective tax-rate. Provide some reasons why the statutory and effective tax-rates may differ.


             Effective tax rate: 30/(90+30) = 25%

             The difference may be due to:
                $ Foreign operations
                $ Tax-privileged domestic transactions such as R&D or Puerto Rico
                     operations
                $ Reversal of tax reserves

(ii)    Determine capital contributions, net of dividends.


         Net div=s = Net Income - CSE
                   =      90   - (500 - 400)
                   = -10

        (This answer assumes that Net Income = Comprehensive Income)

(iii) Determine ROCE; use average CSE in the denominator.



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       ROCE = 90/450 = 20%
(iv)   Determine RNOA; use average NOA in the denominator.


       Operating Earnings (AT) = 90 + .65 x 104 = 157.6


                                   [ (1,400 + 500) + (1,200 + 400) ]
       Average NOA =                                                 = 1,750
                                                   2



       RNOA = 9%

(v)    Reconcile ROCE and RNOA using the formula ROCE = RNOA + leverage x [RNOA - Borrowing Cost (AT)]


       RNOA = 9%; see (iv)

                      Av . Debt 1,300
       Leverage =              =      = 2.89
                      Av . CSE 450

                     Int . Exp .(AT) .65 x 104
       BC(AT) =                     =          = 5.2%
                       Av . Debt       1,300

       Hence
                  9% + 2.89 x [9% - 5.2%] = ROCE = 20%


(vi)   Assume WACC equals 10%. What is your best estimate of the cost of equity capital?


       WACC = 10%

       Leverage = 2.89

       BC(AC) = 5.2%

       CEC = WACC + Leverage x [WACC - BC(AT)]
           = 10% + 2.89 x [10% - 5.2%]
           = 23.87%

(vii) Is the company profitable?


       No; RNOA < WACC (and ROCE < Cost of Equity Capital)


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Part B
Repeat with the following information:
                                                    97                96
           Operating Assets                       3,000              2,600
           Marketable Securities                  1,000              1,000
           Operating Liabilities                  (1,100)           (1,000)
           Common Shareholders= Equity             2,900              2,600


           Operating Earnings (BT)                 315
           Financial Revenue                        60
           Tax Expense                             (100)
           Net Earnings                             275

Note: In answering part (v), replace Aborrowing cost (AT)@ with Areturn on M/S (AT)@; also, leverage is now negative rather
than positive.


(i)        Effective tax rate: 100/375 = 26.7%

(ii)       Net div=s = 275 - 300
                     = -25

(iii) ROCE = 275/2,750 = 10%

(iv)
                               275 - .65 x 60    236
           RNOA =                             =       = 13.5%
                                  1,750         1,750



                                     1,000
(v)        ROCE = 13.5 -                   x [13.5 - 3.9] = 10%
                                     2,750



                                           1,000
(vi) Cost of Equity = 10.0 -                     x [10.0 - 3.9] = 7.78
                                           2,750

(vii)      Yes; RNOA > WACC and ROCE > Cost of Equity

Part C
Which of the two cases, A or B, shows the higher profitability?


Even though ROCE(A) > ROCE(B), it makes sense to say that B is more profitable

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than A. This claim is appropriate since only B exceeds its benchmark(s). Further
note that RNOA(B) > RNOA(A), and WACC(B) = WACC(A).




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