Question

Answer the following questions based on the information in the table. The tax rate is 40 percent and all dollars are in millions. For simplicity, assume that the companies have no other liabilities other than the debt shown next.

	Atlantic Corp.	Pacific Corp.
Earnings before interest and taxes	$450	$   470
Debt (at 8% interest)	$290	$1,490
Equity	$910	$   370

1. Calculate each company’s ROE, ROA, and ROIC.

2. Why is Pacific’s ROE so much higher than Atlantic’s? Does this mean Pacific is a better company? Why or why not?

3. Why is Atlantic’s ROA higher than Pacific’s? What does this tell you about the two companies?

4. How do the two companies’ ROICs compare? What does this suggest about the two companies?

Answer 1

Summary table:

	Atlantic Corp.	Pacific Corp.
Debt (at 8% interest)	290	1490
Equity	910	370
Total Assets = Debt + Equity	1200	1860
Earnings before interest and taxes (EBIT)	450	470
Interest Payment = Debt * Interest Rate	23.2	119.2
Earnings Before Tax = EBIT - Interest Payment	426.8	350.8
Tax Payment (40% of Earnings Before Tax)	170.72	140.32
Net Income = Earnings Before Tax - Tax Payment	256.08	210.48
RoE = Net Income / Equity	28%	57%
RoA= Net Income / Total Assets	21%	11%
RoIC = EBIT (1-Tax Rate) / Invested Capital or Assets	23%	15%

Pacific Corp has a much higher RoE due to it's use of more debt and very less equity (Equity/Assets ratio of ~1/6 in Pacific Corp vs 3/4 in Atlantic Corp). Hence, much lower use of equity with similar returns gives a higher RoE for Pacific Corp. This alone as a measure shows that the company has created higher value for equity shareholders but not a better company in general.

RoA as a measure shows the ability of firm to create value for both bondholders & shareholders together. Atlantic Corp has a higher RoA than Pacific Corp. This shows per unit asset used by both companies, Atlantic Corp has been able to create higher profit & thus, value for both bond & shareholders combined. A similar story is observed by RoIC where we compare the without interest impact or use of assets. Hence, we observe that as a company Atlantic Corp has been performing better.