18 a since goods still in inventory are valued at

Info icon This preview shows pages 9–10. Sign up to view the full content.

View Full Document Right Arrow Icon
18. a Since goods still in inventory are valued at recent versus historical cost. 19. Considering the components of after-tax ROE, there are several possible explanations for a stable after-tax ROE despite declining operating income: 1. Declining operating income could have been offset by an increase in non-operating income (i.e., from discontinued operations, extraordinary gains, gains from changes in accounting policies) because both are components of profit margin (net income/sales). 2. Another offset to declining operating income could have been declining interest rates on any interest rate obligations, which would have decreased interest expense while allowing pre-tax margins to remain stable. 19-9
Image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
3. Leverage could have increased as a result of a decline in equity from: (a) writing down an equity investment, (b) stock repurchases, (c) losses; or, (d) selling new debt. The effect of the increased leverage could have offset a decline in operating income. 4. An increase in asset turnover could also offset a decline in operating income. Asset turnover could increase as a result of a sales growth rate that exceeds the asset growth rate, or from the sale or write-off of assets. 5. If the effective tax rate declined, the resulting increase in earnings after tax could offset a decline in operating income. The decline in effective tax rates could result from increased tax credits, the use of tax loss carry-forwards, or a decline in the statutory tax rate. 20. 2005 2009 (1) Operating margin = Operating income – Depreciation Sales % 5 . 6 542 3 38 = % 8 . 6 979 9 76 = (2) Asset turnover = Sales Total Assets 21 . 2 245 542 = 36 . 3 291 979 = (3) Interest Burden = [Op Inc – Dep] – Int Expense Operating Income – Depreciation 914 . 0 3 38 3 3 38 = 1.0 (4) Financial Leverage = Total Assets Shareholders Equity 54 . 1 159 245 = 32 . 1 220 291 = (5) Income tax rate = Income taxes Pre-tax income % 63 . 40 32 13 = % 22 . 55 67 37 = Using the Du Pont formula: ROE = [1.0 – (5)] × (3) × (1) × (2) × (4) ROE(2005) = 0.5937 × 0.914 × 0.065 × 2.21 × 1.54 = 0.120 = 12.0% ROE(2009) = 0.4478 × 1.0 × 0.068 × 3.36 × 1.32 = 0.135 = 13.5% (Because of rounding error, these results differ slightly from those obtained by directly calculating ROE as net income/equity.) b. Asset turnover measures the ability of a company to minimize the level of assets (current or fixed) to support its level of sales. The asset turnover increased substantially over the period, thus contributing to an increase in the ROE. Financial leverage measures the amount of financing other than equity, including short and long-term debt. Financial leverage declined over the period, thus adversely affecting the ROE. Since asset turnover rose substantially more than financial leverage declined, the net effect was an increase in ROE. 19-10
Image of page 10
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern