Chapter 5
Answers to Review Problems
Finance For Executives – 4th Edition
1. Transactions.
Operatin
g margin
Invested
capital
turnover
Debt
ratio
2. ROICBT , ROCEBT, RONA, ROBA, and ROTA.
Measure Definition Value
ROICBT and ROCEBT are the same. The former refers to the return on the assets used to generate
the 17.4 percent return while the second refers to the amount of capital that was needed to
generate the same return.
ROICBT and RONA are the same since invested capital and net assets are synonymous.
3. Book versus market return on equity.
The two ratios are different because the book value is estimated using past data, up to the end of
The book return on equity is a valuable measure of profitability because it can be structured in a
way to show the impact of different activities of the firm, such as operations, financial, and tax
4. The structure of a firm profitability.
b. The financial structure effect is 1.67 (.10 × .9 × 1.67 = .15 or 15 percent). Since the financial
5. Misuse of the structure of the return on equity.
a. If the firm decides not to replace existing fixed assets, its invested capital will decrease as the
book value of fixed assets will decrease due to increased accumulated depreciation. Its capital
6. 6. Financial leverage.
When the cost of debt is lower than the return on invested capital before tax: it pays to borrow
when the cost of borrowing is lower than the return expected from the investment made by the
7. Industry effect on the structure of the return on equity.
a.
Working capital requirement (WCR) = Accounts receivable + Inventories + Prepaid expenses
– Accounts payable – Accrued expenses
Firm 1
Firm 2
Firm 3
Managerial balance sheets
in millions Firm 1 Firm 2 Firm 3
Invested capital
Capital employed
b.
Operating margin = EBIT/Sales
Return on capital employed = EBIT/Capital employed
Firm 1
Firm 2
Firm 3
The relationship between these ratios and the firms’ return on equity is that ROE is equal to the
c.
Firm 1 is in the retail (nongrocery) industry, Firm 2 is a utility firm, and Firm 3 is in the
computer (software industry).
The most striking feature of Firm 1 is its invested capital turnover of 3.34, which means that the
firm generates $3.34 of revenue per dollar of invested capital, while the other two firms generate
Firm 2 has a slow invested capital turnover, like Firm 3. However, the net fixed assets turnover
of Firm 2 is equal to .52 ($7,132/$13,816), which is half of that of Firm 3, itself equal to 1.05
($22,956/$21,842). This means that Firm 2 is using twice as many fixed assets as Firm 3 to
The most salient feature of Firm 3 is its operating margin, which is close to 50 percent. Such an
extremely high level of operating margin can only be found in industries where there exists some
level of unregulated monopoly power. This situation is most likely to be found in the software
industry than that of the retail or utility industries. Furthermore, note that the working capital