500 of 7 debt total assets of 1500 that earn a 20

Info icon This preview shows pages 22–24. Sign up to view the full content.

View Full Document Right Arrow Icon
- _'. 500 of 7% debt, total assets of $1,500 that earn a 20% return, and a tax rate of 0%. The net income of is $265, computed as follows: $200 Profit from assets financed with equity ($1,000 x 20%) . Profit from assets financed with debt ($500 x 20%) . Less interest expense from debt ($500 x 7%) . Net profit. . $100 (35) 65 $265 company's ROE is 26.5%, computed as $265/$1,000 (assuming income received at year-end for simplicity _ ..•.rerage equity is $1,000). Its RNOA is 20%, FLEV is 0.50 (computed as $500 of average net nonoperating _. - ns divided by $1,000 average equity), and its Spread is 13% (computed as 20% less 7%). This company's shown with the nonoperating return being directly computed, is as follows: ROE = RNOA + [FLEV x Spread] = 20% + [0.50 x 13% ] = 26.5% that when a company's nonoperating activities relate solely to the borrowing of money (without nonoperat- ts), FLEV collapses to the ratio of debt to equity, called the debt-to-equity ratio. ~"""operating Return-Without Debt Financing, but Nonoperating Assets companies, such as many high-tech firms, have no debt, and maintain large portfolios of marketable securi- They hold these highly liquid assets so that they can respond quickly to new opportunities or react to com- - re pressures. With high levels of nonoperating assets and no nonoperating liabilities, the net nonoperating .: ions (NNO) has a negative sign (NNO = Nonoperating liabilities - Nonoperating assets). Likewise, FLEV _ ive: Average NNO (-) / Average Equity (+). Further, net nonoperating expense (NNE = NOPAT - Net ) is negative because investment income is a negative nonoperating expense. However, the net nonoperating percent (NNEP) is positive because the negative NNE is divided by the negative NNO. This causes ROE lessthanRNOA (see computations below). We use the 2010 lO-K ofIntel to illustrate this curious result (Intel no noncontrolling interest). ($ millions, except percentages) 2009 Average Computation 2010 $ 28,652 $(20,778) $ 49,430 $11,464 $ 11,250 $ (214) (0.3648) 38.87% 1.29% 37.58% $ 29,232 $(12,472) $41,704 $ 28,942 $(16,625) $ 45,567 A ............................. •... 0 . ockholders' equity . et income . OPAT . NE ( NOPAT - Net income) . REV . OA ....................... ........ EP . Spread . $(16,625)/$45,567 $11,2501$28,942 $(214)/$(16,625) 38.87%-1.29% ~rs NNO is negative because its investment in marketable securities exceeds its debt. Intel's ROE is 25.16%, it consists of the following: ROE = RNOA + [ FLEV X Spread = 38.87% + [ -0.3648 x 37.58% = 38.87% + [-13.71 %] = 25.16%
Image of page 22

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

View Full Document Right Arrow Icon
3-23 Module 3 I Profitability Analysis and Interpretation Intel's ROE is lower than its RNOA because of its large investment in marketable securities. That is, its excessive liquidity is penalizing its return on equity. The rationale for this seemingly incongruous result is this: Intel's ROE derives from operating and nonoperating assets. Intel's operating assets are providing an outstandi ng return (38.87%), much higher than the return on its marketable securities (1.29%). Holding liquid assets that are less productive means that Intel's shareholders are funding a sizeable level of liquidity, and sacrificing returns in the process. Why? Many companies in high-tech industries feel the need to maintain excessive liquidity to gain flexibility-the flexibility to take advantage of opportunities and to react quickly to competitor maneuvers. Intel's management, evidently, feels that the investment of costly equity capital in this manner will reap future rewards for its shareholders.
Image of page 23
Image of page 24
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