Reference no: EM132239652

PROBLEM 1 Determining Return on Invested Cloud (conceptual)

Quaker Oats, in its annual report, discloses the following:

Financed Objectives: Provide toed shareholder returns (dividends plus than price apperception) that weed both the cost of equity and the S&P 500 stock index over time.

Quaker's total return to shareholders for Year 11 was 34%. That compares quite favor¬ably to our cost of equity for the year, which was about 12%, and to the total return of the S&P 500 stock index, which was 7%. Driving this strong performance, real earnings from continuing operations grew 7.4% over the last five years, return on equity rose to 24.1%. [Quaker Oats' stock price at the beginning and end of Year 11 was $48 and $62. respectively, and the Year 11 dividends are $1.56 per share.]

The Benchmark for Investment

We use our cost of capital as a benchmark, or hurdle rate, to ensure that all projects un¬dertaken promise a suitable rate of return. The cost of capital is used as the discount rate in determining whether a project will provide an economic return on its investment. We estimate a project's potential cash flows and discount these cash flows back to present value. This amount is compared with the initial investment costs to determine whether incremental value is created. Our cost of capital is calculated using the approximate market value weightings of debt and equity used to finance the Company.

Cost of equity + Cost of debt = Cost of capital

When Quaker is consistently able to generate and reinvest cash flows in projects whose returns exceed our cost of capital, economic value is created. As the stock market eval¬uates the Company's ability to generate value, this value is reflected in stock price appreciation.

The east of (plot The cost of equity is a measure of the minimum return Quaker must earn to properly compensate investors for the risk of ownership of our stock. This cost is a combination of a "risk-free" rate and an "equity risk premium:' The risk-free rate (the U.S. Treasury Bond rate) is the sum of the expected rate of inflation and a "real" return of 2% to 3%. For Year 11, the risk-free rate was approximately 8.4%. Investors in Quaker stock expect the return of a risk-free security plus a "risk premium" of about 3.6% to compensate them for assuming the risks in Quaker stock. The risk in holding Quaker stock is inherent in the fact that returns depend on the future profitability of the Com¬pany. Quaker's cost of equity was approximately 12%.

The cost of debt. The cost of debt is simply our after-tax. long-term debt rate, which was around 6.4%.

Required:

a. Quaker reports the "return to shareholders" to be 34%.
(1) How is this return computed (provide calculations)?
(2) How is this return different from return on common equity?

PROBLEM 2 Disaggregating and Analyzing Return on Invested Capital

As a financial analyst at a debt-rating agency, you are asked to analyze return on invested capital and asset utilization (turnover) measures for ZETA Corporation. Selected financial information for Years 5 and 6 of ZETA Corporation are reproduced in the Comprehensive Case chapter (sec Case CC-2).

Required
a. Compute the following return measures for Year 6 (assume a 50% tax rate):
(1) Return on net operating assets. (2) Return on common equity.

PROBLEM 3 Analyzing Return on Assets

Two auto dealers. Legend Auto Sales and Reliable Auto Sales, compete in the same area. Both purchase autos for $10,000 each and sell them for S12,000 each. Both maintain 10 cam on the lot at all times. A local basketball legend owns Legend Auto Sales. As a result. Legend sells 100 cars each year, while Reliable sells only 50 cars each year. The dealerships have no other revenues or expenses.

Required:
The town banker has denied Reliable Auto Sales a loan because its return on net operating assets is inferior to its rival. The owner of Reliable Auto Sales has engaged you to help explain why its return on net operating assets is inferior to that of Legend Auto Sales. Please prepare a memo¬randum for Reliable Auto Sales explaining the problem. Present quantitative support for your conclusions.

PROBLEM 4 Analyzing Property - Plant, and Equipment Turnover

A machine that produces hockey pucks costs $20,500 and produces 10 pucks per hour. Two simi¬lar companies purchase the machine and begin producing and selling pucks. The first company. Northern Sales, is located in International Falls, Minnesota. The second company, Southern Sales, is located in Huntsville. Alabama Northern Sales operates the machine 20 hours per day to meet customer demand. Southern Sales operates the machine 10 hours per day to meet customer demand. Sales data for the first month of operations are given below:

Required:

Calculate the property, plant, and equipment turnover ratio (sales divided by average PPE) for both Northern Sales and Southern Sales. Explain how this ratio impacts the return on net oper-ating assets of each company (assume the profit margin for each company is the same and that there has been no change in PPE).