MBA 620 FINANCIAL MANAGEMENT (CH. 2 REVIEW)
The Board of Directors of Collins Entertainment, Inc., has been pressuring its CEO to
boost ROE. During a recent interview on CNBC, he announces his plan to improve the
firm's financial performance. He will raise prices on all of the company's products by
10%. He justifies the plan by observing that ROE can be decomposed into the product
of profit margin, asset turnover, and financial leverage. By raising prices, he will
increase the profit margin and thus ROE. Does this plan make sense? Why or why not?
- Answers -The CEO is correct that ROE is the product of profit margin, asset turnover,
and financial leverage, but an increase in prices will likely not necessarily increase ROE
because increased prices will likely reduce sales. If operating costs are fixed, the profit
margin could actually fall when prices rise. Even if operating costs are variable, a
decrease in sales will reduce the asset turnover, and thus reduce ROE. It is uncertain
whether the effect of the increase in the profit margin on ROE will outweigh the effect of
the decrease in asset turnover. When thinking about levers of performance, it is
important to remember that changes in company strategy can affect multiple levers,
often in different directions.
Which company would you expect to have a higher price-to-earnings ratio: Alphabet or
railroad company Union Pacific? Why? - Answers -Price-to-earnings ratios are highly
dependent on future growth expectations. Therefore, high-growth Alphabet would likely
have a higher ratio than low-growth Union Pacific.
Which company would you expect to have a higher debt-to-equity ratio: a financial
institution or a high-technology company? Explain your response. - Answers -The
financial institution should have the higher debt-to-equity ratio because the liquid,
relatively safe nature of its assets enables it to borrow more money at attractive rates.
Additionally, in the case of banks, deposit insurance enables the institution to collect low
cost deposits. The principal asset of financial institutions tends to be typically safe loans
that generate predictable income streams. The uncertain income stream of the high-
tech company makes it less creditworthy.
Would you expect an appliance manufacturer or a grocer to have higher profit margin?
Why? - Answers -The appliance manufacturer should have a higher profit margin
because it adds more value to its product than a grocer does and hence can charge a
higher markup over cost.
Would you expect a jewelry store or an online bookstore to have a higher current ratio?
Explain your response. - Answers -The jewelry store should have a higher current ratio.
Jewelry stores typically need to have a lot of expensive display inventory on hand and
often offer payment plans to customers. Online bookstores, on the other hand, typically
carry little inventory and rely on credit card sales involving little accounts receivable.
True or false: A company's assets-to-equity ratio always equals one plus its liabilities-to-
equity ratio. - Answers -True
, Let L = liabilities, E = equity, and A = assets.
A/E = 1 + L/E, A/E = (E + L)/E
True or false: A company's return on equity (ROE) will always equal or exceed its return
on assets (ROA). - Answers -True
The numerators of the two ratios are identical. ROA can exceed ROE only if assets are
less than equity, which implies that liabilities would have to be negative.
True or false: A company's collection period should always be less than its payables
period. - Answers -False
A payables period longer than the collection period would be nice because trade credit
could finance accounts receivable. However, payable periods are typically determined
by industry practice and the relative bargaining power of firms involved; depending on a
company's circumstances, it may have to gracefully put up with a collection period
longer than its payables period.
True or false: A company's current ratio must always equal or exceed its acid test ratio.
- Answers -True
The two ratios are the same except that inventory, which is never negative, is
subtracted from the numerator to calculate the acid test.
True or false: All else equal, a firm would prefer to have a higher asset turnover ratio. -
Answers -True
Decomposing ROE shows that a higher asset turnover ratio increases ROE. Thus, a
firm wants to maximize asset turnover (all else being equal, of course).
True or false: Two firms can have the same earnings yield but different price-to-
earnings ratios. - Answers -False
Earnings yields and price-to-earnings ratios are the inverse of one another. If two firms
have identical earnings yields, they will have identical price-to-earnings ratios.
True or false: Ignoring taxes and transactions costs, unrealized paper gains are less
valuable than realized cash earnings. - Answers -False
Ignoring taxes and transaction costs, unrealized gains can always be realized by the act
of selling, so they must be worth as much as a comparable amount of realized gains.
Your firm is considering the acquisition of a very promising technology company. One
executive argues against the move, pointing out that because the technology company
is presently losing money, the acquisition will cause your firm's return on equity to fall. Is
The Board of Directors of Collins Entertainment, Inc., has been pressuring its CEO to
boost ROE. During a recent interview on CNBC, he announces his plan to improve the
firm's financial performance. He will raise prices on all of the company's products by
10%. He justifies the plan by observing that ROE can be decomposed into the product
of profit margin, asset turnover, and financial leverage. By raising prices, he will
increase the profit margin and thus ROE. Does this plan make sense? Why or why not?
- Answers -The CEO is correct that ROE is the product of profit margin, asset turnover,
and financial leverage, but an increase in prices will likely not necessarily increase ROE
because increased prices will likely reduce sales. If operating costs are fixed, the profit
margin could actually fall when prices rise. Even if operating costs are variable, a
decrease in sales will reduce the asset turnover, and thus reduce ROE. It is uncertain
whether the effect of the increase in the profit margin on ROE will outweigh the effect of
the decrease in asset turnover. When thinking about levers of performance, it is
important to remember that changes in company strategy can affect multiple levers,
often in different directions.
Which company would you expect to have a higher price-to-earnings ratio: Alphabet or
railroad company Union Pacific? Why? - Answers -Price-to-earnings ratios are highly
dependent on future growth expectations. Therefore, high-growth Alphabet would likely
have a higher ratio than low-growth Union Pacific.
Which company would you expect to have a higher debt-to-equity ratio: a financial
institution or a high-technology company? Explain your response. - Answers -The
financial institution should have the higher debt-to-equity ratio because the liquid,
relatively safe nature of its assets enables it to borrow more money at attractive rates.
Additionally, in the case of banks, deposit insurance enables the institution to collect low
cost deposits. The principal asset of financial institutions tends to be typically safe loans
that generate predictable income streams. The uncertain income stream of the high-
tech company makes it less creditworthy.
Would you expect an appliance manufacturer or a grocer to have higher profit margin?
Why? - Answers -The appliance manufacturer should have a higher profit margin
because it adds more value to its product than a grocer does and hence can charge a
higher markup over cost.
Would you expect a jewelry store or an online bookstore to have a higher current ratio?
Explain your response. - Answers -The jewelry store should have a higher current ratio.
Jewelry stores typically need to have a lot of expensive display inventory on hand and
often offer payment plans to customers. Online bookstores, on the other hand, typically
carry little inventory and rely on credit card sales involving little accounts receivable.
True or false: A company's assets-to-equity ratio always equals one plus its liabilities-to-
equity ratio. - Answers -True
, Let L = liabilities, E = equity, and A = assets.
A/E = 1 + L/E, A/E = (E + L)/E
True or false: A company's return on equity (ROE) will always equal or exceed its return
on assets (ROA). - Answers -True
The numerators of the two ratios are identical. ROA can exceed ROE only if assets are
less than equity, which implies that liabilities would have to be negative.
True or false: A company's collection period should always be less than its payables
period. - Answers -False
A payables period longer than the collection period would be nice because trade credit
could finance accounts receivable. However, payable periods are typically determined
by industry practice and the relative bargaining power of firms involved; depending on a
company's circumstances, it may have to gracefully put up with a collection period
longer than its payables period.
True or false: A company's current ratio must always equal or exceed its acid test ratio.
- Answers -True
The two ratios are the same except that inventory, which is never negative, is
subtracted from the numerator to calculate the acid test.
True or false: All else equal, a firm would prefer to have a higher asset turnover ratio. -
Answers -True
Decomposing ROE shows that a higher asset turnover ratio increases ROE. Thus, a
firm wants to maximize asset turnover (all else being equal, of course).
True or false: Two firms can have the same earnings yield but different price-to-
earnings ratios. - Answers -False
Earnings yields and price-to-earnings ratios are the inverse of one another. If two firms
have identical earnings yields, they will have identical price-to-earnings ratios.
True or false: Ignoring taxes and transactions costs, unrealized paper gains are less
valuable than realized cash earnings. - Answers -False
Ignoring taxes and transaction costs, unrealized gains can always be realized by the act
of selling, so they must be worth as much as a comparable amount of realized gains.
Your firm is considering the acquisition of a very promising technology company. One
executive argues against the move, pointing out that because the technology company
is presently losing money, the acquisition will cause your firm's return on equity to fall. Is
