Chapter: Chapter 10: Analyzing Performance

True/False

1. Since profit is measured over an entire year, whereas capital is measured at only one point in
time, it is recommended that return on invested capital (ROIC) use the average of starting and
ending invested capital.

Ans: [True]
Response: []

Multiple Choice

2. With respect to the performance measures return on invested capital (ROIC), return on
equity (ROE), and return on assets (ROA), which of the following is most accurate concerning
the relative superiority of the three as analytical tools for understanding a company’s
performance?
a) ROE is better than ROA, which is better than ROIC.
b) ROA is better than ROIC, which is better than ROE.
c) ROIC is better than ROA, which is better than ROE.
d) ROE is better than ROIC, which is better than ROA.

Ans: [c]
Response: [ROIC is a better analytical tool for understanding the company’s performance than
return on equity (ROE) or return on assets (ROA) because it focuses solely on a company’s
operations. Return on equity mixes operating performance with capital structure, making peer
group analysis and trend analysis less meaningful.]

3. Compute ROIC given the following information: EBITA = $800, revenues = $2,200, invested
capital = $4,000, operating cash tax rate = 34%.
a) 6.8 percent.
b) 13.2 percent.
c) 24.0 percent.
d) 36.3 percent.

McKinsey/Valuation 59
Ans: [b]
Response: [

4. You are an equity analyst and have computed the following figures for two cement
companies. The first, CementCo, has NOPLAT of $1,550 million, invested capital without
goodwill of $15,000 million, and goodwill of $1,950 million. The second, CementExports, has
NOPLAT of $1,750 million, invested capital without goodwill of $16,000 million, and no
goodwill. If the cost of capital for both firms is 10 percent, what is the ROIC for each company?
Which company is creating value in this year?
a) ROIC excluding goodwill is 10.3 percent for CementCo and 10.9 percent for CementExports;
both companies are creating value.
b) ROIC including goodwill is 9.1 percent for CementCo and 10.9 percent for CementExports;
both companies are creating value.
c) ROIC including goodwill is 9.1 percent for CementCo and 10.9 percent for CementExports;
only CementExports is creating value.
d) ROIC including goodwill is 9.1 percent for CementCo and 10.9 percent for CementExports;
neither of the companies is creating value.

Ans: [c]
Response: [ROIC = NOPLAT/Invested capital
For CementCo:
ROIC excluding goodwill = 1,550/15,000 = 10.3%
ROIC including goodwill = 1,550/(15,000 + 1,950) = 9.1%
For CementExports:
ROIC excluding and including goodwill (as there is no goodwill) = 1,750/16,000 = 10.9%
One should include goodwill, as this required an outlay by the firm.]

True/False

5. An analyst would include goodwill in invested capital when measuring aggregate value
creation for a company’s shareholders.

Ans: [True]
Response: []

McKinsey/Valuation 60
6. ROIC excluding goodwill is useful when measuring underlying operating performance of the
company and its businesses, and it is useful for comparing performance against peers and to
analyze trends.

Ans: [True]
Response: []

7. A company’s ROIC is driven by its ability to maximize profitability (EBITA divided by revenues
or the operating margin), optimize capital turnover (measured by revenues over invested
capital), or minimize operating taxes.

Ans: [True]
Response: []

Use the following table, which provides historical data for SnacksCo, a manufacturer of snack
foods, to answer the next four questions. Assume an operating tax rate of 30 percent and a cost
of capital of 9 percent.

Income statement Year 1 Year 2

Revenues 540.0 555.0

Cost of sales (350.0) (360.5)

Selling, general, and
administrative (50.0) (50.5)

Depreciation (10.0) (10.5)

EBIT 130.0 133.5

Interest expense (7.5) (7.5)

Gain/(loss) on sale of assets – (30.0)

Earnings before taxes 122.5 96.0

Taxes (24.8) (21.5)

McKinsey/Valuation 61
Net income 97.7 74.5

Balance sheet Year 1 Year 2

Operating cash 10.6 15.0

Excess cash and marketable
securities 102.8 100.0

Accounts receivable 90.0 94.5

Inventory 150.0 157.5

Current assets 353.4 367.0

   

Property, plant, and equipment 206.7 219.8

 Equity investments 180.0 180.0

Total assets 740.1 766.8

     
Accounts payable 116.6 119.6

Short-term debt 45.0 45.0

Accrued expenses 90.1 89.0

Current liabilities 251.7 253.7

     

Long-term debt 68.4 80.6

Common stock 120.0 120.0

Retained earnings 300.0 312.5

     

Total liabilities and equity 740.1 766.8

Multiple Choice

McKinsey/Valuation 62
8. What is SnackCo’s operating margin in year 2?

a) 13.4 percent.
b) 16.8 percent.
c) 24.0 percent.
d) 35.3 percent.

Ans: [b]

Response: [NOPLAT = Operating profit * (1 – Tax rate)

Operating profit = Revenues – Cost of sales – Selling costs – Depreciation – Taxes
Operating profit in year 2 = 555.0 – 360.5 – 50.5 – 10.5 = 133.5
NOPLAT in year 2 = 133.5 * (1 – 30%) = 93.5
Operating margin = NOPLAT/Revenues = 93.5/555 = 16.8%]

9. What is SnackCo’s capital turnover in year 2 using average invested capital?

a) 2.1
b) 2.0
c) 1.5
d) 0.5

Ans: [a]
Response: [Invested capital = Working capital + PPE
Working capital = Working cash + Accounts receivable + Inventories – Accounts payable –
Accrued expenses
Working capital in Year 2 = 15 + 94.5 + 157.5 – 119.6 – 89 = 58.4
Invested capital in year 2 = 58.4 + 219.8 = 278.2
Working capital in Year 1 = 10.6 + 90 + 150 – 116.6 – 90.1 = 43.9
Invested capital in year 1 = 43.9 + 206.7 = 250.6
Average invested capital = (278.2 + 250.6)/2 = 264.4
Capital turnover = Revenues/Average invested capital = 555/264.4 = 2.1 ]

10. What is SnackCo’s ROIC in year 2?

a) 20.3 percent.
b) 24.8 percent.
c) 33.6 percent.
d) 35.4 percent.

McKinsey/Valuation 63
Ans: [d]
Response: [ROIC in year 2 (based on average invested capital) = 93.5/264.4 = 35.4%
Operating margin = NOPLAT/Revenues = 93.5/555 = 16.8%
Capital turnover = Revenues/Average invested capital = 555/264.4 = 2.1x]

True/False

11. SnackCo is creating value in year 2.

Ans: [True]
Response: [Since the ROIC is greater than the WACC, value is being created.]

Multiple Choice

12. Which of the following is the best method of determining whether the financial
performance between competitors is sustainable?
a) Linking operating drivers directly to return on capital.
b) Comparing the respective ROE and ROA measures.
c) Breaking ROE down into ROIC, tax, interest rate, and leverage effects.
d) Distinguishing between pretax ROIC and the operating-cash tax rate.

Ans: [a]
Response: []

  2015 2016
Current assets $860 $896
Current liabilities 710 818
Debt in current liabilities 1 39
Long-term debt 506 408
Total assets 2,293 2,307
Capital expenditures 111 117
Change in deferred taxes –29 –20
Sales 4,100 4,192
Operating expenses 3,307 3,260

McKinsey/Valuation 64
Rental expense 0 248
General expenses 562 528
Depreciation 139 136
Interest expense 39 30
Income taxes 5 8

13. Using the preceding table, if receivables, inventories, and other current assets are $520 in
2015, then what is the number of days in cash?
a) 28 days.
b) 29 days.
c) 30 days.
d) 31 days.

Ans: [c]
Response: [Days = 365 ´ (Cash/Revenues). Cash = Current assets – (Receivables + Inventories +
Other current assets). Cash = $860 – $520 = $340. Days = 365 ´ ($340/$4,100) = 30.27 days.]

14. In order to get a more accurate forecast of revenue growth, an analyst should remove the
effects of which of the following?
I. Deferred taxes.
II. Changes in currency values.
III. Mergers and acquisitions.
IV. Changes in accounting policies.
a) I and II only.
b) I and III only.
c) III and IV only.
d) II, III, and IV only.

Ans: [d]
Response: [The three prime culprits distorting revenue growth are the effects of changes in
currency values, mergers and acquisitions, and changes in accounting policies. Strip out from
revenues any distortions created by these effects in order to base forecast revenues for
valuation on sustainable precedents.]

15. Assuming that both the acquiring and target firms have fiscal years ending on December 31,
if the target is acquired on December 1, 2015, which of the following is the most accurate?
a) Revenues of the target would be consolidated from 2016 onward.

McKinsey/Valuation 65
b) Revenues of the target would be consolidated 100 percent for 2015.
c) Revenues of the target would be consolidated post-acquisition—that is, one month of
revenues of the target for 2015.
d) No consolidation of revenues will happen.

Ans: [c]
Response: []

True/False

16. Liquidity measures the company’s ability to meet obligations over the short term.

Ans: [True]
Response: []

17. Leverage measures the company’s ability to meet obligations over the long term.

Ans: [True]
Response: []

Multiple Choice

18. The company’s ability to meet short-term obligations is measured with ratios that
incorporate three measures of earnings. Which of the following is NOT one of those measures
of earnings?
a) Earnings before interest, taxes, and amortization (EBITA).
b) Earnings before interest, taxes, depreciation, and amortization (EBITDA).
c) Earnings before interest, taxes, amortization, and preferred dividends (EBITAD).
d) Earnings before interest, taxes, depreciation, amortization, and rental expense (EBITDAR).

Ans: [c]
Response: []

McKinsey/Valuation 66
True/False

19. By using the debt-to-EBITDA ratio, one can build a more comprehensive picture of the risk
of leverage.

Ans: [True]
Response: [There has been a large increase in the use of convertible securities in recent years.
Many convertibles compensate through the potential conversion to equity rather than interest,
making interest coverage ratios artificially high.]

20. To evaluate leverage in the recent low-interest-rate environment, many analysts are now
evaluating debt multiples such as debt to EBITDA or debt to EBITA.

Ans: [True]
Response: [Over the past decade, interest rates have dropped to unprecedented lows, making
interest coverage ratios uncharacteristically high. Given its much larger denominator, the debt-
to-EBITDA multiple tends to be more stable, making assessments over time much clearer.]

Multiple Choice

21. With regard to the interest coverage ratio, which of the following is the most accurate?
a) If near-term bankruptcy is an issue, EBITDA can be used to measure survival only over the
short term.
b) EBITDA should be used to measure survival over both the short and the long term.
c) EBITA should be used to measure survival only in the short term (vs. long term).
d) None of the above are true.

Ans: [a]
Response: [If near-term bankruptcy is an issue, EBITDA can be used to meet interest
obligations, and maintenance capital will consequently fall to zero. Unless the company plans to
wind down operations, depreciation must eventually be reinvested to maintain operations.
Therefore, EBITDA can be used to measure survival only over the short term. Over the long
term, EBITA is a better ratio.]

McKinsey/Valuation 67
22. Use the following data to answer the question: What are the three interest coverage ratios
based on pretax income and interest expense?

  2015 2016
Current assets $860 $896
Current liabilities 710 818
Debt in current liabilities 1 39
Long-term debt 506 408
Total assets 2,293 2,307
Capital expenditures 111 117
Change in deferred taxes –29 –20
Sales 4,100 4,200
Operating expenses 3,307 3,260
Rental expense 0 248
General expenses 562 528
Depreciation 139 136
Interest expense 39 30
Income taxes 5 8

a) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 5.47, 5.47, and
1.48, respectively.
b) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 2.36, 5.92, and
13.73, respectively.
c) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 0.93, 5.47, and
1.48, respectively.
d) For 2016, interest coverage ratios based on EBIT, EBITDA, and EBITDAR are 0.93, 5.47, and
13.73, respectively.

Ans: [c]
Response: [

EBIT EBITDA EBITDAR

2015
Interest Interest (Interest + Rental expense)
Numerator 92 231 231
Denominator 39 39 39
Ratio 2.36 5.92 5.92

EBIT EBITDA EBITDAR

2016 Interest Interest (Interest + Rental expense)
Numerator 28 164 412
Denominator 30 30 278
Ratio 0.93 5.47 1.48

McKinsey/Valuation 68
]

23. For a given company, the return on invested capital (ROIC) is 13.5 percent, the tax rate is 34
percent, and the pretax cost of debt is 8.8 percent. If its debt-to-equity ratio is equal to 2.0,
what is the return on equity (ROE)?
a) 16.30 percent.
b) 17.80 percent.
c) 28.88 percent.
d) 25.30 percent.

Ans: [c]
Response: [ROE = ROIC + {ROIC – (1 – T) * kd} * D/E
ROE = 13.5% + {13.5% – (1 – 34%) * 8.8%} * 2
ROE = 28.88%]

24. Given that ROIC, the interest rate on debt, and the debt-to-equity ratio are constant, how
will increasing the tax rate affect ROE?
a) Decrease it.
b) Not affect it.
c) Increase it.
d) There is no set relationship.

Ans: [c]
Response: []

True/False

25. An analysis of a company’s historical financial performance should go back a maximum of

five years.

Ans: [False]
Response: [An analyst should look back as far as possible (at least 10 years). Long time horizons
will allow you to determine whether the company and industry tend to revert to some normal
level of performance, and whether short-term trends are likely to be permanent.]

McKinsey/Valuation 69