Describe the relationship between return on assets and return on common shareholders' equity
RELATION BETWEEN RETURN ON ASSETS AND RETURN ON COMMON SHAREHOLDERS' EQUITY
For profitable firms, it is common for ROCE to exceed ROA. ROA measures the profitability of a firm before any payments to the suppliers of financing. Each of the various providers of financing has a claim on some portion of the income in the numerator of ROA. Creditors receive the contractual interest to which they have a claim; the tax savings the firm realizes from deducting interest for tax purposes reduces the interest cost to the firm. Preferred shareholders, if any, receive the stated dividend amounts on the preferred stock. Any remaining income belongs to the common shareholders; that is, common shareholders have a residual claim on all income after creditors and preferred shareholders receive amounts contractually owed them. Thus,
The pool of operating income in the numerator of ROA goes first to lenders in the form of after-tax interest expense, then any remaining amount to preferred shareholders in the form of preferred dividends, and then the residual to the common shareholders.
ROCE will exceed ROA whenever ROA exceeds the after-tax cost of borrowing plus any dividends required for preferred shareholders. Using lower-cost borrowed funds and then earning a rate of return on those funds higher than their cost increases the return to the common shareholders and is a phenomenon called financial leverage. The common
shareholders earn a higher return, but they undertook more risk in their investment. The risk results from the firm incurring debt obligations with fixed payment amounts and dates.
You might also like to view...
Long-lived assets only include the tangible assets of an organization
a. True b. False Indicate whether the statement is true or false
The most traditional feedback role of leaders is that of a feedback ______.
a. seeker b. receiver c. giver d. analyzer
Which of the following is the best description of organizational culture?
A. conditions that prevent new companies from entering an industry B. a system of shared values about what is important and beliefs about how the world works C. the network that obtains raw materials, transforms them into products, and distributes them to customers D. the process of searching out information that is unavailable to most people and sorting through it to interpret what is important and what is not E. the process of comparing an organization's practices and technologies with those of other companies
The relative proportion of variable, fixed, and mixed costs in a company is known as the company's:
A. cost structure. B. contribution margin. C. product mix. D. relevant range.