Question #1
Reading: Reading 13 Integration of Financial Statement Analysis Techniques
PDF File: Reading 13 Integration of Financial Statement Analysis Techniques.pdf
Page: 1
Status: Incorrect
Correct Answer: A
Your Answer: B
Question
An analyst finds return-on-equity (ROE) (based on beginning of the year equity) a good measure of management performance and wants to compare two firms: Firm A and Firm
Answer Choices:
A. 18.4 and 14.3
B. 16.0 and 18.0
C. 17.1 and 16.9
Explanation
The ROE for Firm A is adjusted for the $400,000 loss on discontinued operations and the
$300,000 non-recurring gain. The ROE for Firm B is adjusted to remove the effects of the
$2.6 million one-time gain.
The first step in this problem is to solve for equity using ROE. Then, "normalize" net
income by adjusting for discontinued operations and non-recurring items. Then, solve for
"normalized" ROE.
Firm A:
18% = 3,200,000 / EquityA
EquityA = 17,777,778 (rounding)
Normalized Net IncomeA = 3,200,000 + (1 – 0.36)(400,000 – 300,000)
Normalized ROEA = 3,264,000 / 17,777,778 = 18.360%
Firm B:
16% = 16,000,000 / EquityB
EquityB = 100,000,000
Normalized Net IncomeB = 16,000,000 + (1 – 0.36)(–2,600,000)
Normalized ROEB = 14,336,000 / 100,000,000 = 14.336%
18.360 and 14.336 are closest to 18.4 and 14.3