Analysts and investors often use return on equity (ROE) to compare profitability of a company with
other firms in the industry. ROE is considered a very important measure, and managers strive to
make the company's ROE numbers look good.
If a firm takes steps that increase its expected future ROE, its stock price will
Increase
Based on your understanding of the uses and limitations of ROE, which of the following projects
will a manager likely choose if his or her bonus is solely based on the ROE of the next project?
• Project X, with 35% ROE and a large investment, generating high expected cash flows
• Project Y, with 40% ROE and a small investment, generating low expected cash flows
Suppose you are trying to decide whether to invest in a company that generates a high expected
ROE, and you want to conduct further analysis on the company's performance. If you wanted to
conduct a trend analysis, you would:
Compare the firm's financial ratios with other firms in the industry for a particular year
Analyze the firm's financial ratios over time
You decide also to conduct a qualitative analysis based on the factors summarized by the American
Association of Individual Investors (AAII). According to your understanding, a company with one
key customer is considered to be
risky than companies with several customers.
The American Association of Individual Investors (AAIT) has identified several qualitative factors
that should also be considered when evaluating a company's likely future financial performance.
Consider the scenario and indicate how you would expect the described event or situation to affect
the described business organization.
Northern Services Inc.
To date, Northern has been a one-product company. It manufactures, sells, and services
only one product, AM-FM radios, and that item is in the market-saturation stage of its
product life cycle. As a result, Northern's profits are declining due to increased competition
from new products and competing firms.
For several reasons, attempts to develop and introduce new products have not been
successful.
