Answer The Questions About Return On Invested Capital (roic) Quiz

1. What does the term 'growth' refer to in the context of a company?

The rate at which the company's NOPLAT and cash flow grow each year....g= ROIC x IR

The geographical locations where the company operates

The size of the company's workforce

The number of products the company sells

In the context of a company, 'growth' specifically refers to the rate at which the company's NOPLAT (Net Operating Profit Less Adjusted Taxes) and cash flow grow each year, calculated as g = ROIC (Return on Invested Capital) x IR (Investment Rate).

Explanation

In the context of a company, 'growth' specifically refers to the rate at which the company's NOPLAT (Net Operating Profit Less Adjusted Taxes) and cash flow grow each year, calculated as g = ROIC (Return on Invested Capital) x IR (Investment Rate).

2. What is the key value driver formula used to calculate value assuming constant ROIC and growth?

Value= NOPLAT (1- [g/ROIC]) / (WACC-g) ...................assumes constant ROIC and growth

Value = NOPLAT / ([g-ROIC] * WACC)

Value = NOPLAT * (1 - g/ROIC) * WACC

Value = NOPLAT * (1 - [ROIC/g]) / (WACC - g)

3. How does return on invested capital (ROIC) affect a company's cash flow? Explain the relationship between ROIC, growth, and cash flow.

ROIC is used to generate future cash flows. Growth and ROIC are drivers of value, value beings the generation of cash flows. The amount of value created is the difference between cash inflows and outflows. The cash flow created by both drivers must be more than the cost of capital to create value. A higher ROIC will lead to lower expenditures and higher cash flows......investment rate= growth/ROIC

Higher ROIC results in lower cash flow for a company.

ROIC has no impact on a company's cash flow.

Growth has no correlation with ROIC or cash flow.

ROIC plays a critical role in determining a company's future cash flows by influencing value creation. Higher ROIC and growth lead to increased cash flow generation, resulting in creation of value for the company.

Explanation

ROIC plays a critical role in determining a company's future cash flows by influencing value creation. Higher ROIC and growth lead to increased cash flow generation, resulting in creation of value for the company.

4. Why should a company or investor analyze growth and ROIC if value is based on discounted cash flows?

A company or investor should only focus on discounted cash flows and not consider growth or ROIC

Higher ROIC will lead to less investment and higher cash flows. Discounting the smaller cash flows will lead to a smaller present value. However, one must note that a lower p/e can be deceiving with a lower ROIC. Higher growth with a low ROIC can reduce value. High ROIC and high growth leads to the most value.

Growth and ROIC are irrelevant when determining the value of a company based on discounted cash flows

ROIC has no impact on the future cash flows of a company

Analyzing growth and ROIC is important because it directly impacts the future cash flows of a company, which are the basis for discounted cash flow valuation. Higher ROIC and growth can significantly increase the overall value of a company.

Explanation

Analyzing growth and ROIC is important because it directly impacts the future cash flows of a company, which are the basis for discounted cash flow valuation. Higher ROIC and growth can significantly increase the overall value of a company.

5. Under what circumstances does growth destroy value?

Growth destroys value when the ROIC is low and growth is high. Faster growth can destroy capital in that instance.

Growth destroys value when the ROIC is high and growth is low. Slower growth can lead to capital destruction.

Growth destroys value when the ROIC is low and growth is high. Faster growth can destroy capital due to inefficiencies.

Growth never destroys value, regardless of the ROIC or growth rate.

Growth destroys value only when the company is in a declining industry.

The correct answer highlights the specific scenario where growth leads to value destruction, emphasizing the importance of a low ROIC and high growth rate. The incorrect answers either misinterpret this scenario or present false information about growth and value destruction.

Explanation

The correct answer highlights the specific scenario where growth leads to value destruction, emphasizing the importance of a low ROIC and high growth rate. The incorrect answers either misinterpret this scenario or present false information about growth and value destruction.

6. Which type of business, a software company or an electric utility, would benefit more from improving ROIC than from increasing growth? Why?

The software company would likely benefit most by an increase in ROIC. ***However, one must remember that growth may not always return the same ROIC.

An electric utility would benefit more from improving ROIC as compared to a software company.

Both a software company and an electric utility would benefit equally from improving ROIC.

An electric utility would benefit more from increasing growth as compared to a software company.

Return on Invested Capital (ROIC) is typically more critical for software companies as opposed to electric utilities due to the nature of their operations and potential for higher returns. Electric utilities have stable revenues and may focus more on growth initiatives, whereas software companies prioritize efficient use of capital to generate higher returns.

Explanation

Return on Invested Capital (ROIC) is typically more critical for software companies as opposed to electric utilities due to the nature of their operations and potential for higher returns. Electric utilities have stable revenues and may focus more on growth initiatives, whereas software companies prioritize efficient use of capital to generate higher returns.

7. Why does organic growth often create more value than growth from acquisitions? Describe how different types of organic growth might create different amount of value.

Acquisitions always result in greater value creation than organic growth, as they immediately provide synergies and cost reductions.

Acquisitions have a higher chance of success due to the established model and cash flows, unlike organic growth which carries a higher risk of failure and development costs.

Organic growth frequently have the highest returns because they don't require much new capital; companies can just add new products to existing lines and distribution systems. Investments are not required all at once and can be scaled back/canceled....acquisitions require the entire transaction be made up front (this includes a premium and expected cash flows). The return is often only slightly higher than the cost of capital and value is only created by overlaps/synergies that result in revgrowth, cost reductions, or better capital allocation (ex. J&J purchasing Pfizer's consumer health business for 600M savings per yr...or J&J's purchase of neutrogena for intl exposure)....It also does not reflect the risk of failure. Acquisitions already have a working model with cash flows while organic growth may consist of failure and development costs.

Organic growth requires more capital upfront compared to acquisitions, which can hinder the value created by the growth strategy.

8. What is the conservation of value principle? Provide some examples of where it might apply.

The conservation of value principle states that creating value without increasing cash flows is beneficial.

The conservation of value principle does not consider the redistribution of value as a factor in determining value creation.

The conservation of value principle refers to maintaining a fixed amount of value at all times.

The principle is that anything that does not increase cash flows doesn't create value. Gimmicks that redistribute value do not change value.

The conservation of value principle emphasizes the importance of focusing on activities that lead to increased cash flows, rather than simply redistributing existing value. By understanding this principle, individuals and businesses can make strategic decisions that truly create value.

Explanation

The conservation of value principle emphasizes the importance of focusing on activities that lead to increased cash flows, rather than simply redistributing existing value. By understanding this principle, individuals and businesses can make strategic decisions that truly create value.

9. Under what circumstances would changing a company's capital structure affect its value?

Changing the capital structure has no impact on a company's value

Share repurchases always create value for shareholders

Changing the capital structure can definitely influence cash flows and value. Interest payments are often deductible. Debt can also cause managers to be more diligent because they must have cash available to pay on time (thus increasing cash flow). Debt can also simply reduce cash flow...share repurchases only create value if it reduces the chance of management investing the money unwisely. When companies purchase undervalued shares, it only transfers value from those who sold to those who did not.

Increasing debt in the capital structure always leads to higher profits

Changing a company's capital structure can have various impacts on its value, such as influencing cash flows, the deductibility of interest payments, managerial diligence, and the potential effects of share repurchases. It is important to carefully evaluate the implications of changes in a company's capital structure.

Explanation

Changing a company's capital structure can have various impacts on its value, such as influencing cash flows, the deductibility of interest payments, managerial diligence, and the potential effects of share repurchases. It is important to carefully evaluate the implications of changes in a company's capital structure.

10. What is financial engineering? When does it create value?

Financial engineering involves the physical construction of buildings to increase a company's value.

Financial engineering is the process of creating counterfeit money to increase a company's capital reserves.

Financial engineering refers to the process of altering financial statements to mislead investors and regulators.

It is "the design, analysis, and construction of financial contracts to meet the needs of enterprises"...aka the use of financial instruments or structures other than straight debt and equity, to manage a company's capital structure and risk profile (ex. structured debt, derivatives, securitization)...most don't create value. REIT structured income payments increase cash flows for the company since shareholders pay the taxes. CDOs through special purpose entities/vehicles do not create value (value is actually destroyed via intermediaries). Fake value was created via ratings agencies earning fees from banks.

Financial engineering is a complex field that focuses on creating financial contracts and structures to meet the needs of enterprises and manage their risk profiles. It is not about counterfeiting money, constructing buildings, or misleading stakeholders through financial statement alterations.

Explanation

Financial engineering is a complex field that focuses on creating financial contracts and structures to meet the needs of enterprises and manage their risk profiles. It is not about counterfeiting money, constructing buildings, or misleading stakeholders through financial statement alterations.

11. How would one apply the conservation of value principle to acquisitions?

Value is automatically created in any acquisition regardless of the financial performance.

Value created in acquisitions is solely dependent on the price paid for the acquired company.

Unless the acquisition is increasing cash flows as aresult of revgrowth, cost reductions, or better capital allocation- value is not being created

The conservation of value principle does not apply to acquisitions.

The correct answer highlights that the conservation of value principle in acquisitions focuses on the importance of increasing cash flows through revenue growth, cost reductions, or better capital allocation to create value. The incorrect answers provide misconceptions or incorrect applications of the conservation of value principle in acquisitions.

Explanation

The correct answer highlights that the conservation of value principle in acquisitions focuses on the importance of increasing cash flows through revenue growth, cost reductions, or better capital allocation to create value. The incorrect answers provide misconceptions or incorrect applications of the conservation of value principle in acquisitions.

12. How do diversifiable and nondiversifiable risks affect a company's cost of capital?

If a risk is diversifiable, then the company can easily eliminate the risk through diversification. When nondiversifiable, the cost of capital is higher because compensation is required for risks which cannot be eliminated.

Nondiversifiable risks lead to a decrease in a company's cost of capital.

Diversifiable risks have no impact on a company's cost of capital.

Diversifiable risks increase a company's cost of capital, while nondiversifiable risks decrease it.

Diversifiable risks can be mitigated through diversification, reducing the overall risk faced by the company, while nondiversifiable risks cannot be eliminated and therefore require higher compensation, leading to a higher cost of capital.

Explanation

Diversifiable risks can be mitigated through diversification, reducing the overall risk faced by the company, while nondiversifiable risks cannot be eliminated and therefore require higher compensation, leading to a higher cost of capital.

13. How should a company determine the amount of cash flow risk it should take on? How can it mitigate risks with extreme outcomes that could potentially bankrupt the company but are unlikely to occur?

A company should avoid all cash flow risks to ensure financial stability.

A company should always take on maximum cash flow risk to maximize potential profits.

There is no specific amount of cash flow risk a company must take on. However, it is important that the upside potential outweighs the downside risk, whether the company can absorb the loss, and whether they can reduce the magnitude of the loss. One should not engage in any risks which have large negative spillover effects to the rest of the company.

A company should blindly take risks with extreme outcomes without considering the potential consequences.

It is important for a company to carefully assess the risks it takes on and consider the potential impact on its financial health and overall stability. While it is important to take some level of risk to grow and succeed, it is equally important to balance this with prudent risk management strategies.

Explanation

It is important for a company to carefully assess the risks it takes on and consider the potential impact on its financial health and overall stability. While it is important to take some level of risk to grow and succeed, it is equally important to balance this with prudent risk management strategies.

14. What does investment rate (IR) represent?

The total revenue generated by the business

Growth/ROIC....the portion of NOPLAT invested back into the business

The business's market share

The profit margin of the business

The investment rate (IR) is specifically calculated as the growth divided by the return on invested capital (ROIC), representing the portion of net operating profit less adjusted taxes (NOPLAT) that is reinvested back into the business for growth.

Explanation

The investment rate (IR) is specifically calculated as the growth divided by the return on invested capital (ROIC), representing the portion of net operating profit less adjusted taxes (NOPLAT) that is reinvested back into the business for growth.

15. What is the cost of capital?

The price charged by investors for bearing the risk that the company's future cash flows may differ from what they anticipate when they make the investment.

The total expenses incurred by a company in a specific period of time.

The monetary value assigned to a company's assets and liabilities.

The amount of money required to start a new business.

The cost of capital is the price charged by investors for bearing the risk associated with a company's future cash flows. It is not related to total expenses, monetary value of assets, or initial startup costs.

Explanation

The cost of capital is the price charged by investors for bearing the risk associated with a company's future cash flows. It is not related to total expenses, monetary value of assets, or initial startup costs.

16. What is cash flow risk?

Risk that companies face when investing in the stock market.

Risk that companies must identify and manage- meaning the uncertainty about future cash flows

Risk that companies face due to fluctuations in interest rates.

Risk that companies intentionally take to increase profitability without considering potential consequences.

Cash flow risk refers to the uncertainty surrounding future cash flows that companies must be aware of and actively manage to ensure financial stability.

Explanation

Cash flow risk refers to the uncertainty surrounding future cash flows that companies must be aware of and actively manage to ensure financial stability.

17. What does NOPLAT stand for?

Represents the profits generated from the company's core operations after subtracting the income taxes related to the core operations

Net income before taxes represents the total income of a company before tax expenses.

Gross profit margin represents the percentage of revenue that exceeds the cost of goods sold.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and represents a company's earnings before various non-cash expenses.

NOPLAT is a financial metric used to measure a company's profitability from its core operations after adjusting for taxes. It is different from net income before taxes, gross profit margin, and EBITDA.

Explanation

NOPLAT is a financial metric used to measure a company's profitability from its core operations after adjusting for taxes. It is different from net income before taxes, gross profit margin, and EBITDA.

18. What is net investment?

Invested capital (t+1) - invested capital (t)...........it is the increase in invested capital from one year to the next

Investment returns

Net income

Invested capital (t) + Invested capital (t+1)

Net investment is calculated as the difference between the invested capital at the beginning of the year (t) and the invested capital at the end of the year (t+1), representing the increase in invested capital over time.

Explanation

Net investment is calculated as the difference between the invested capital at the beginning of the year (t) and the invested capital at the end of the year (t+1), representing the increase in invested capital over time.

19. What is Free Cash Flow (FCF)?

Is the cash flow generated by the core operations of the business after deducting investments in new capital.....FCF= NOPLAT - net investment

Free cash flow is the net income of a company without any deductions.

Free cash flow is the total cash flow including investments in new capital.

Free cash flow is the cash flow generated solely from external financing activities.

Free Cash Flow (FCF) is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. It represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. It is important for analyzing a company's ability to pay dividends, reduce debt, and pursue growth opportunities.

Explanation

Free Cash Flow (FCF) is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. It represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. It is important for analyzing a company's ability to pay dividends, reduce debt, and pursue growth opportunities.

20. What is Return on Invested Capital (ROIC)?

C. The amount of debt a company has compared to its equity

B. The percentage of profits distributed to shareholders

The return the company earns on each dollar invested in the business....NOPLAT / Invested Capital

A. The total revenue generated by the company

Return on Invested Capital (ROIC) is a financial metric that measures how effectively a company uses its capital to generate profit. It is a key indicator of a company's financial performance and efficiency in utilizing invested capital.

Explanation

Return on Invested Capital (ROIC) is a financial metric that measures how effectively a company uses its capital to generate profit. It is a key indicator of a company's financial performance and efficiency in utilizing invested capital.

21. What does WACC stand for?

The total cost of debt and equity financing for a company.

The maximum cost companies are willing to pay for financing.

The average cost of capital that companies aim to achieve for funding their projects.

The rate of return that investors expect to earn from investing in the company and therefore the appropriate discount rate for the FCF

Weighted Average Cost of Capital (WACC) is the rate of return that investors expect to earn from investing in the company and therefore the appropriate discount rate for the Free Cash Flows (FCF). It represents the average cost of financing a company's activities through debt and equity.

Explanation

Weighted Average Cost of Capital (WACC) is the rate of return that investors expect to earn from investing in the company and therefore the appropriate discount rate for the Free Cash Flows (FCF). It represents the average cost of financing a company's activities through debt and equity.