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Utilization of Capital

A. Describe some of the advantages and disadvantages of ROE as a measure of corporate profitability. What is a typical level of ROE, and how does one know if the ROE reported by a given company reflects an adequate return on investment?

B. Define the profit margin, total asset turnover, and financial leverage factors that contribute to ROE. Discuss the advantages and disadvantages of each of these potential sources of high ROE.
C. Based upon the finding reported in Table 11.3, discuss the relation between P/E ratios and ROE, profit margins, total asset turnover, and financial leverage. In general, which component of ROE is the most useful indicator of the firm's ability to sustain high profit rates in the future?

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A. Describe some of the advantages and disadvantages of ROE as a measure of corporate profitability. What is a typical level of ROE, and how does one know if the ROE reported by a given company reflects an adequate return on investment?

What Is ROE?
By measuring how much earnings a company can generate from assets, ROE offers a gauge of profit-generating efficiency. The relationship between the company's profit and the investor's return makes ROE a particularly valuable metric to examine.
ROE Calculation
A company's ROE ratio is calculated by dividing the company's net income by its shareholder equity, or book value.
Net Income/Average Common Equity

SIGNAL OF FINANCIAL SUCCESS: Utilization of Capital
ROE offers a useful signal of financial success since it might indicate whether the company is growing profits without pouring new equity capital into the business. It turns out, however, that a company cannot grow earnings faster than its current ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot increase its earnings faster than 15% annually without borrowing funds or selling more shares. But raising funds comes at a cost: servicing additional debt cuts into net income and selling more shares shrinks earnings per share by increasing the total of shares outstanding.

So ROE is, in effect, a speed limit on a firm's growth rate, which is why money managers rely on it to gauge growth potential. In fact, many specify 15% as their minimum acceptable ROE when evaluating ...

Solution Summary

Utilization of Capital is assessed.

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