Home Work 1. In 2005 IBM had a return on equity of 26. 7 percent, whereas Hewlett-Packard’s return was only 6. 4 percent. Use the decomposed ROI framework to provide possible reasons for this difference based on the data below: IBM HP NOPAT/Sales 9. 0% 2. 7% Sales/Net Assets 2. 16 2. 73 Effective After-Tax Interest Rate 2. 4% 1. 1% Net Financial Leverage 0. 42 -0. 16 Answer: IBM Analysis Return on Operation Asset = NOPAT/sales * Sales/net assets = 9. 00%* 2. 16 =19. 44% Borrowing multiplier = ROA- EATR =19. 44%-2. 40% =17. 04% Return on Leverage = Borrowing multiplier * Net Financial leverage =17. 04%*0. 42 = 7. 15%
ROE = ROA* Net Financial Leverage 26. 7% = X*0. 42 X=63. 57 ROA = 63. 57% Decompose the return on assets: ROA = Net income/Sales * Sales/Assets 63. 57 = X * 2. 16 Net income/Sales=29. 43% Hewlett Packard Analysis Return on Operation Asset = NOPAT/sales * Sales/net assets =2. 70%* 2. 70 =7. 37% Borrowing multiplier = ROA- EATR =7. 37%-1. 10% =6. 27% Return on Leverage = Borrowing multiplier * Net Financial leverage =6. 2 %*(0. 16) = -1. % ROE = ROA* Net Financial Leverage 6. 40% = X*(0. 16) X=-40% ROA = -40% Decompose the return on assets: ROA = Net income/Sales * Sales/Assets -. 40 = X * 2. 73 Net income/Sales=-14. 5% From the onset, it appears IBM’s 26. 7% return on equity indicate that its managers are generating more return for its shareholders than HP that have 6. 4 percent return on equity. In other to access the decomposed ROI framework above to provide the difference based on data of IBM and Hewlett Packard, we will need to assess certain drivers such as Return on Equity/ Return on Asset which helps to measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested and how effect the corporate uses debt to increase it equity, that is return on leverage.Order now
Assess the amount of sales generated for every dollar’s worth of asset. This is done by measuring the two firms’ efficiency at using its assets in generating sales or revenue. That is, the higher the number the better. It also indicates pricing strategy; companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. After, careful analysis of the two firms, one could conclude IBM strategy is the best because the firm maintained a high profit margins which resulted to low asset turnover of 19. 4% ( 9% * 2. 16) while HP maintained a low profit margins tend to have high asset turnover of 7. 37%( 2. 70% * 2. 73). Financial leverage (FL) takes the form of a loan or other borrowings (debt), the proceeds of which are sometimes re-invested with the intent to earn a greater rate of return than the cost of interest. If the firm’s rate of return on assets (ROA) is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow because assets = equity + debt.
From the above analysis we could see that IBM ROA of 63. 75% is higher than that of HP -40%, this indicates that HP’s ROA is lower than the interest rate, and its ROE will be lower than if it did not borrow firm. We can also conclude that the two firms have different financing policy because IBM has a net financial leverage of 0. 42 that of HP is (0. 16). One could tell that IBM strategy is effective because the company is taking advantage of debt financing; one of the best way to run a business, while HP maintain more of cash than debt financing.
IBM strategy gave the firm more advantage because Leverage allows greater potential returns to the investor Net Profit Margin The ratio of net income to sales is the profit margin which is indicates how much the company is able to keep as profit for each dollar of sales it makes. IBM’s higher net profit margin of 29. 43 percent is an indication of its higher profitability level than HP’s negative net profit margin of 14. 65 percent. 2.
In a period of rising prices, how would the following ratios be affected by the accounting decision to select LIFO, rather than FIFO, for inventory valuation? * Gross Margin- Using LIFO will result in lower gross margin versus a higher gross margin if FIFO is used. * Current Ratio. Current ratio is lower under LIFO because inventory is understated. * Asset Turnover – Inventories will be understates causing turnover ratio to increase. * Debt-to-equity ratio- Using LIFO will result in higher debt to equity ratio * Average tax rate – Has no significant impact