The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher than the industry average, yet its ROA is the same as the industry average. How can you explain this?
ATO to be lower than industry average.
ROA also known as Return on Assets is the calculation of percentage of income the company is generating against its total assets.
ROA = (EBIT / Sales) x (Sales / Average total assets) = Return on sales x ATO
This implies that if the Crusty pie can have its ATO lower than its industry average, it can have a return on sales higher than the industry average and ROA equal to the industry average.
Adams’s research report (see the previous problem) continued as follows: “With a business expansion already under way, the expected profit surge should lead to a much higher price for Universal Auto stock. We strongly recommend purchase.”
a. Discuss the business-cycle approach to investment timing. (Your answer should describe actions to be taken on both stocks and bonds at different points over a typical business cycle.)
b. Assuming Adams’s assertion is correct (that a business expansion is already under way), evaluate the timeliness of his recommendation to purchase Universal Auto, a cyclical stock, based on the business-cycle approach to investment timing.
Universal Auto is a large multinational corporation headquartered in the United States.
For segment reporting purposes, the company is engaged in two businesses: production of motor vehicles and information processing services.
The motor vehicle business is by far the larger of Universal’s two segments. It consists mainly of domestic United States passenger car production, but it also includes small truck manufacturing operations in the United States and passenger car production in other countries. This segment of Universal has had weak operating results for the past several years, including a large loss in 2012. Although the company does not reveal the operating results of its domestic passenger car segments, that part of Universal’s business is generally believed to be primarily responsible for the weak performance of its motor vehicle segment.
Idata, the information processing services segment of Universal, was started by Universal about 15 years ago. This business has shown strong, steady growth that has been entirely internal: No acquisitions have been made.
An excerpt from a research report on Universal prepared by Paul Adams, a CFA candidate, states: “Based on our assumption that Universal will be able to increase prices significantly on U.S. passenger cars in 2013, we project a multibillion-dollar profit improvement . . .”
Use the following case in answering Problems 26 – 28:
Institutional Advisors for All Inc., or IAAI, is a consulting firm that primarily advises all types of institutions such as foundations, endowments, pension plans, and insurance companies. IAAI also provides advice to a select group of individual investors with large portfolios. One of the claims the firm makes in its advertising is that IAAI devotes considerable resources to forecasting and determining long-term trends; then it uses commonly accepted investment models to determine how these trends should affect the performance of various investments. The members of the research department
of IAAI recently reached some conclusions concerning some important macroeconomic trends. For instance, they have seen an upward trend in job creation and consumer confidence and predict that this should continue for the next few years. Other domestic leading indicators that the research department at IAAI wishes to consider are industrial production, average weekly hours in manufacturing, S&P 500 stock prices, M2 money supply, and the index of consumer expectations.
In light of the predictions for job creation and consumer confidence, the investment advisers at IAAI want to make recommendations for their clients. They use established theories that relate job creation and consumer confidence to inflation and interest rates and then incorporate the forecast movements in inflation and interest rates into established models for explaining asset prices. Their primary concern is to forecast how the trends in job creation and consumer confidence should affect bond prices and how those trends should affect stock prices.
The members of the research department at IAAI also note that stocks have been trending up in the past year, and this information is factored into the forecasts of the overall economy that they deliver. The researchers consider an upward-trending stock market a positive economic indicator in itself; however, they disagree as to the reason this should be the case.
Stock prices are useful as a leading indicator. To explain this phenomenon, which of the following is most accurate?
a. Predict future interest rates and reflect the trends in other indicators.
b. Do not predict future interest rates, nor are they correlated with other leading indicators; the usefulness of stock prices as a leading indicator is a mystery.
c. Reflect the trends in other leading indicators only and do not have predictive power of their own.
The FI Corporation’s dividends per share are expected to grow indefinitely by 5% per year.
a. If this year’s year-end dividend is $8 and the market capitalization rate is 10% per year, what must the current stock price be according to the DDM?
b. If the expected earnings per share are $12, what is the implied value of the ROE on future investment opportunities?
c. How much is the market paying per share for growth opportunities (that is, for an ROE on future investments that exceeds the market capitalization rate)?
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