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Chapter: Chapter 02: Fundamental Principles of Value Creation
True/False
1. Since value is based on discounted cash flows, a company or an investor need not analyze
growth and return on invested capital (ROIC).
2. Return on invested capital and revenue growth determine how revenues are converted into
cash flows, and value is created only when return on invested capital is greater than cost of
capital.
Multiple Choice
3. If the growth rate of a company is 2.1 percent and the ROIC is 9 percent, what is the
investment rate?
a) 23.3 percent.
b) 30.4 percent.
c) 45.5 percent.
d) 69.6 percent.
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Ans: [a]
Response: [Investment rate = Growth/ROIC = 2.1%/9% = 0.23333]
4. If the growth rate of a company is 5 percent and the investment rate is 40 percent, what is
the ROIC?
a) 800 percent.
b) 8 percent.
c) 2 percent.
d) 12.5 percent.
5. If the investment rate of a company is 10 percent and the ROIC is 20 percent, what is the
growth rate?
a) 5 percent.
b) 50 percent.
c) 2 percent.
d) 200 percent.
6. Focusing on improving earnings and short-term cash flow will consequently lead to value
creation.
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7. When a company has an ROIC greater than its cost of capital, faster growth increases value,
but when it has an ROIC less than its cost of capital, what is the effect on value?
a) Faster growth creates value.
b) Faster growth destroys value.
c) Growth doesn’t impact value creation.
d) None of the above are true.
8. Companies can increase their value by shifting the listing country, as demonstrated by the
fact that U.S. companies have had higher valuation multiples than companies based in Asia.
9. For a given incremental increase in revenue from each of the following sources of growth,
which source would generally create the most shareholder value?
a) Reducing costs.
b) Acquiring businesses.
c) Expanding an existing market.
d) Introducing new products to market.
10. Companies can generally create more value by competing to lure customers away from
rivals than by expanding their portfolios by either developing new products or expanding the
market.
11. Organic growth often creates more value than growth from acquisitions.
12. A company with an ROIC of 45 percent and a cost of capital of 8 percent is considering an
investment opportunity of similar risk to its existing investments. If the new opportunity would
generate a 30 percent ROIC, what should the company do?
a) The company should invest in this project, as 30 percent is pretty close to the 45 percent that
the company currently achieves.
b) The company should not invest in the project, since the return is lower than its current
return of 45 percent.
c) The company should invest in the project, as its return is greater than the cost of capital.
d) The company should not invest in the project, since it already enjoys a high ROIC and the
new investment will dilute the overall returns.
13. A 10 percent increase in value is most likely to result from a 10 percent increase in which of
the following?
a) Growth.
b) ROIC.
c) NOPLAT.
d) WACC.
14. Economic profit consists of the spread between ROIC and cost of capital and is useful in
determining which business units or investment opportunities would create more value.
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15. For a given company, next year’s NOPLAT is $50. For the foreseeable future, the growth rate
will be 3 percent, the ROIC will be 12 percent, and the weighted average cost of capital (WACC)
will be 10 percent. Using the key driver formula, calculate the value of the company.
a) $536
b) $1,667
c) $714
d) $500
16. For a given company, next year’s NOPLAT is $200. For the foreseeable future, the growth
rate will be 5 percent, the ROIC will be 10 percent, and the WACC will be 8 percent. Using the
key driver formula, calculate the value of the company.
a) $2,500
b) $4,000
c) $6,667
d) $3,333
17. When ROIC equals the cost of capital, there is no relationship between growth and value.
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Ans: [True]
Response: [When ROIC = WACC in the constant growth model, value = NOPLAT/WACC.]
Short Answer
18. Explain how the current level of return on invested capital (ROIC) should influence
managers’ decision concerning their focus on the two sources of value creation.