Why to analyse how much to increase unit prices to sell to obtain 20% Return on Equity (ROE) by End of Y2?
Among the main reasons why investors risk their capital in a company is to obtain a good to excellent return on their investment, taking into account the risk that the company may not achieve the forecasted level of sales, which may cause losses and significantly reduce equity.ROE is defined as: Profit (Loss) / Equity* 100%. ROE is an indicator used in financial analysis to measure the profitability of the investment in the firm. It is used mainly for firms that are running concerns, say, that have more than 4 years of operation. It is included in this course as an illustration of the analysis on profitability of equity. However shorter terms than four years can also use ROE analysis as an indicator of profitability in less than four years, which is applicable to start ups. The simulation methodology compares the baseline scenario with the target scenario. Management has to analyse the action to be taken to reach the objective, such as an increase of capital, increase of market share, increase in unit prices, decrease of costs, and increase in bank borrowing. Finally implement the action.
Shareholders have demanded that ROE must be at least 20% at the end of Y2.
As a yardstick ROE 10% to 15% is judged as a good return in the UK and worldwide markets.The higher the return over 5% the higher the “equity premium” for making an investment that bears a risk of insolvency and therefore the invested capital being lost. As can be seen in the Exhibit below A a good return would be between 15% and 10%, while a very good return would be between 15% and 20%, over 20% the ROE would be judged as excellent. Below 10% it would be considered barely satisfactorily given the risk taken in investing in the firm. A negative return means that the company has made a loss in the accounting period.
|Return on Equity Ratio|
|< 10%||10% – 15%||15 – 20%||> 20%|
|Profit/Loss (1)||Equity (2)||ROE (1)/(2)|
THE CASEShareholders have demanded that after two years of launching operations there must be a ROE of at least 20%. Management has been tasked by the Board to come up with a plan to increase the unit price in Y2 from that in the baseline scenario to ensure that equity in December Y2 yields at least a 20% return = Equity Y2 + 20% Equity Y2. The procedure to perform a “What If” simulation to obtain a ROE of 20% in December Y2:
|Step 1 Baseline|
|Go to > Business Game > Group 2 > Profit and Loss Statements >
Net Profit of Y2:
|Go to > Business Game > Group 2 > Balance Sheets > Equity in December Y2:||259,400|
|Profit deficit to obtain target in December Y2: (i) first find net profit of 20% over equity in Y2;
(ii) then if there has been a profit compare this value with target
or if there is a loss add this value to profit target of 20%; find total profit gap (deficit).
|a. Relationship between equity in two subsequent periods: E₁ = E₀ + π₁ = → E₀ = E₁ - π₁ b. where: E₁ = equity in current period. In baseline balance sheet Y2 E₁ = 259,400 c. E₀ = equity in previous period. In baseline balance sheet Y1 E₀ = 457,600 (1) d. π₁ = profit or loss in current period. Loss in baseline current period, Y2: π₁ = -148,200 (2) e. Target π₁ = 0.2 * E₁ f. Target relationship between equity in two subsequent periods: E₀ = E₁ - 0.2 * E₁ = 0.8 * E₁ g. E₁ = E₀ / 0.8 = (1) / 0.6 = 457,600 / 0.8 = 572,000 (3) h. Thus π₁ = 0.2 * (3) = 0.2 * 572,000 = 114,400 (4) i. Total increase in profit to obtain profit target: loss in Y2 + profit target in Y2 = (2) + (4) = 148,200 + 114,400 = 262,600|
|Step 2 Management Action: Increase unit price of licenses sold|
|Find the needed increase in unit price for licenses sold during Y2: total increase in profit / number of licenses sold||Increase in unit price = 262,600 / 59 = 4,450.|
|Enter in Cash Flow Y2 he increase the unit price:||= 30,000 + 4,450 = 34,450|
|Step 3 Find Net Profit and Equity Y2|
|Go to > Business Game > Group 2 > Profit and Loss Statements > Net Profit Y2:||π₁=112,800 (4)|
|Go to > Business Game > Group 2 > Balance Sheets > Equity Y2:||E₁= 520,400 (5)|
|ROE target:||π₁ / E₁ = (4) / (5) = 22%, just above the 20% ROE target|
ROE Target: Increase unit price to 34,450 in Y2 to achieve 20% ROE at the end of Y2.
Ratio AnalysisThe following discussion is based on the baseline case.
Why to calculate financial ratios?Financial ratios are useful to management in evaluating the outcome of its strategic decisions, such as an increase of market share by selling more licenses or an increase in profit by increasing selling prices or decreasing expenses. Crucial financial data contained in the Income Statement and the Balance Sheet, such as cash at bank, current assets, total assets, costs of sales, equity, can be extracted and used to calculate financial ratios.
How do financial ratios can help financial management?They provide management with a better visualisation of the outcome of its decisions as is the case with an increase in the unit price of licenses sold. The importance of financial ratios lies not in obtaining a single value for any given year, but in obtaining ratios for several years, Y1, Y2, Y3 and Y4 so that a trend can be obtained and thus a long term projection of the financial performance can be analysed. Financial ratios allow the comparison of the financial performance of the business in a summarised manner, say, a single indicator of ROE per year, as is the case of the ROE values on the table above, where ROE for Y1, -0.96, has gradually improved to -0.57 in Y2, 0.68 in Y3 and 0.52 in Y4. Thus it provides an instant photograph of the trend of ROE during 4 years which shows that the return to initial investment went from very negative in the first year, improving to almost to a small loss in the second year, to a good profit in Y3 and then to a good retained profit again in Y4 after paying tax and distributing dividends to shareholders.
Why are long term trends of financial performance important?The primary objective of the firm is survival in the long term, namely, long after the first year of operations. A long term view of the projected financial ratios, under varying scenarios can contribute to better understand the financial performance of the company, and if needed take corrective action so that the main goals of survival and profitability are achieved. ROE in the baseline case in Y1, Y2, Y3 and Y4, are respectively -0.96, -0.57, 0.68 and 0.52. These ratios indicate that the Owners have had losses in the first two years of operation and then their invested capital (Equity) recovers in Y3 and Y4. The target of this simulation is to increase selling price for licenses sold in Y2 so that equity in December Y2 yields at least a 20% return. When unit price increases to 34,450 in Y2 Equity in Y2, becomes 521,950 while profit increases to 114,350, meaning ROE of 0.22. ROE in Y3 is 0.55. The ratios are calculated as follows: 1. In the Business Simulation Game > Group 2 > Cash Flow Year 2, Enter the new unit price, 34,450, for all licenses sold in Y2, as referred above. 2. Then review the Business Simulation Game > Groups 1, 2, 3, 4 > Profit and Loss Statements and Balance Sheets, find out the new Profit and Loss and Equity values for Y1, Y2, Y3, Y4 as shown below. The Exhibit and the Graph below show ROE for Y1, Y2, Y3 and Y4 in the baseline and in Case 3.4.
|Case 3.4||Baseline Case|
|End of Period||Profit or Loss (1)||Equity (2)||ROE (1)/(2)||Profit or Loss (3)||Equity (4)||ROE (3)/(4)|
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