# Return on Equity and Assets

Payne Products's sales last year were an anemic $1.6 million but with an improved product mix it expects sales growth to be 25% this year, and Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 60%. Payne's debt interest rate is currently 8%. You are to evaluate three different current asset policies:

(1) a tight policy in which current assets are 45%of projected sales,

(2) a moderate policy with 50% of sales tied up in current assets, and

(3) a relaxed policy requiring current assets of 60% of sales.

Earnings before interest and taxes is expected to be 12% of sales. Payne's tax rate is 40%.

a. What is the expected return on equity under each current asset level?

b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? Why or why not?

c. How would the overall riskiness of the firm vary under each policy?

The answers are:

rNOM = 75.26%

EAR - 109.84%

Please could you show the workings either in excel or any other way. Thanks.

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#### Solution Preview

Please see the attached file:

Payne Products's sales last year were an anemic $1.6 million but with an improved product mix it expects sales growth to be 25% this year, and Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 60%. Payne's debt interest rate is currently 8%. You are to evaluate three different current asset policies:

(1) a tight policy in which current assets are 45%of projected sales,

(2) a moderate policy with 50% of sales tied up in current assets, and

(3) a relaxed policy requiring current assets of 60% of sales.

Earnings before interest and taxes is expected to be 12% of sales. Payne's tax rate is 40%.

a. What is the expected return on equity under each current asset level?

b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? Why or why not?

c. How would the overall riskiness of the firm vary under each policy?

The answers are:

rNOM = 75.26%

EAR - 109.84%

a. What is the expected return on equity ...

#### Solution Summary

Return on equity for 3 different levels of current assets (current assets as a % of sales) has been calculated.

Rate of return on Equity (ROE)

To procure the basic financial documents for the company go to Intel's 2006 Financial Statements. Then, following the instructions laid out in this presentation on financial ratios and the examples given in this summary, perform a basic financial analysis of the company by calculating the following indicators (There are multiple years in the statements so make sure you use the 2006 figures in making your calculations):

1. Rate of return on Equity (ROE) = Net Income / Shareholders' Equity

This ratio can be re-written as a product of the three principal components:

ROE = (Net Income/Sales) x (Sales/Assets) x (Assets/Shareholders' Equity)

The three components are actually: profit margin, asset turnover, and financial leverage, respectively.

2. Return on Assets (ROA) = Profit margin x Asset turnover = Net income/Assets

3. Gross Margin = Gross profit/Sales

4. Inventory turnover = Cost of goods sold / Ending inventory

5. The Collection Period = Accounts receivable/Credit sales per day, where credit sales per day (or simply "sales per day" are computed by dividing total sales for the year by 365.

6. Fixed-asset turnover = Sales/Net property, plant and equipment

7. Financial leverage ratios:

Debt-to-assets ratio = Total liabilities/Total assets

Debt-to-equity ratio = Total liabilities/Shareholders' equity

8. Liquidity ratios:

Current ratio = Current assets/Current liabilities

Acid test = (Current assets - Inventory)/Current liabilities

Intel's financials use a few different labels than the equations above. Here are some hints:

Total sales is equal to Net Revenue in the Income Statement

Cost of goods sold is equal to Cost of sales in the Income Statement

Current liabilities and current assets are different from total liabilities and total assets. Make sure you add current liabilities and other long-term liabilities to come up with total liabilities.

When you have finished your calculations, summarize them in a brief (2-3 page) report, and describe any conclusions that you can draw about the company from examining these figures. Be sure to show your calculations. If there doesn't seem to be any discernible pattern of information that you can draw forth, say so, but at least tell us a little bit about what you tried to look for. On the basis of one module, you won't have the skill necessary to make a very sophisticated analysis, but at least you can get a sense of how analysts look at the numbers and make them into meaning.

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