Midterm Questions - Chapter 4 Finance (+1 Q on cost structure)

Difference between ROIC and ROE

-> ROIC includes also the capital that was available through loans/debt making.

Explain different sources of cost advantage and give examples.

1) Economies of scale: Unit cost decrease in case of larger volumes. Prodcution becomes more efficient as the number of goods being produced inreases. Reasons: fixed-costs are spread over a larger number of goods and variable cost/unit can be lower because of operational efficencies and synergies. Possible economies of scale through - spread of high fixed costs, specialisation (Ex: In the car industry the production of 3 Mio.units/year are required to achieve efficient processes. For such a complex product the production should be split in many parts with specialized workers. This requires less training and more efficiency but a large output is necessary.), bulk buying (supermarkets get lower average cost by buying in bulk), marketing economies (advertisement->Coca-Cola vs. Schweppes), financial (bigger firms gets lower rate of interest on borrowing), ... 2) Economies of scope: Unit cost decrease in case of more product lines sharing infrastructure cost. The increase in the variety of goods produced results in a decrease in the average cost of production. Ex: Sales forces of pharma company, From soft-drink to alcoholic drinks (same distribution network) 3) Economies of learning: Unit cost decrease or effectiveness increases through repitition and optimization. Ex: Repetition of a certain production process-> Textile industry, manufacturing of shirts... 4) Improvements in production techniques: Lower unit cost due to process innovations and/or reengineering of production processes. (from lines to modular platforms -> VW 5) Product design for lower cost: Lower unit cost due to standardization of components/platforms, design for manufacture -> also VW, use same standardized parts in different vehicles 6) Lower input cost: Lower unit cost due to location, ownership of low cost inputs, non-unionized labour, bargaining power -> Emerging country, less regulation, lower transportation 7) Superior capacity utilization: Lower unit cost due to fixed cost shared over larger volume, capacity adjustment

Explain the utility of an income statement, a balance sheet and a cash flow statement

1) Income statement: Shows operational performance for a period of time 2) Shows how the assets and operating business are fincanced at one point of a time 3) Shows solvency and ability to generate cash for a period of time

Which ratio to choose when?

1) Performance indications WITHIN the SAME industry: Gross margin & Operating margin. Not appropriate for comparison between various industries as they vary strongly. 2) WITHIN and ACCROSS industries: ROIC. Better than ROA because ROIC excludes current liabilities. Better than ROE because ROIC determines performance independent of financing decisions.

Economic value added (EVA)

= Capital employed* x (ROIC-WACC) -> (*=total non-current liabilities-total shareholder equity)/other liabilities-deferred tax liabilities) -> economic profit includes the "opportunity cost". A company creates shareholder value if EVA>0

Return on invested capital (ROIC, often also ROCE)

= EBIT-Tax/Equity + Debt* (*long-term debts with interest bearing responsibility). To measure how well a company is investing its capital and it efficiency to allocate it profitably. Looks at total investments capital returns. Should be compared to its WACC to determine if company is creating value.

Return on Equity (ROE)

= Net income/shareholders equity. The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Measures the efficiency of profit generation of a company. For most firms, an ROE level around 10% is considered strong and covers its costs of capital.

Net margin

= Net profit/Sales. How much of each $ earned by the company is translated into profit. Net profit = Revenue - COGS - Operating Expenses - Interest and Taxes Interpretation: 1) Revenue problem 2) COGS too high 3) Operating expenses too high 4) Paying more interest and taxes

Return on Assets (ROA)

= Operating profit/Total Assets -> An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.

Operating margin

= Operating profit/sales. Also known as earning before interest and taxes (if no non-operating income). Measures the ability of a company to extract profit from its operations. Operating Profit = Operating Revenue - Cost of Goods Sold (COGS) - Operating Expenses - Depreciation Interpretation: 1) Higher sales needed 2) Lower COGS? -> match with gross margin? 3) Lower operating expenses (day-to-day costs that help keep the business going such as: Accounting&Legal Fees, Marketing&Sales, Office supplies, R&D)

Gross margin

= Sales-COGS/Sales. Objective of a company is to perform as high as possible. Extend to which a firm adds value to the goods&services it buys. Interpretation: 1) Higher sales are needed 2) Lower cost of goods sold -> higher wages? who are the suppliers? economies of scale possible in raw material orders? ...

WAAC (weighted average cost of capital)

Calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation. Since cost of capital is the return that equity owners (or shareholders) and debt holders will expect, so WACC indicates the return that both kinds of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC is an investor's opportunity cost of taking on the risk of investing money in a company.To calculate WACC, multiply the cost of each capital component by its proportional weight and take the sum of the results.

What is the logic behind the DuPont-Model?

To understand sources of satisfactory/unsatisfactory performance. How we used it: Disaggregation of ROIC to identify the "value drivers" (for detailed approach see notes)