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Req. 2
Rate of return on total assets
Rate of return on common shareholders’ equity
(continued)
Net income + Interest expense = Average total assets =
0.071 × 100
=
Net income – Preferred dividends Average common shareholders’ equity
=
0.086 × 100
* Total shareholders’ equity Less: Preferred equity Common shareholders’ equity
$25,000 + $7,200 ($492,000 + $410,000/2)
=
P 13-6B $32,200 $451,000
=
= 7.1%
=
$25,000 – (10,000 × $0.20) ($337,500* + $200,000)/2
=
$23,000 $268,750
= 8.6%
$367,000 29,500 $337,500
Req. 3 These rates of return suggest weakness. Return on common shareholders’ equity is only 1.5% higher than return on assets. An 8.6% rate of return on common shareholders’ equity is good considering bank savings rates are currently below 2%; a 12% return is considered excellent in most industries.
Preparing a fairly complex balance sheet will refine students’ understanding of the shareholders’ equity of a corporation. This will help students understand what they are buying (shareholders’ equity) when they purchase a company’s shares as an investment. This problem also exposes students to two widely-used measures of profitability—return on assets and return on common shareholders’ equity. Students, investors, and others can evaluate investments on the basis of their returns on assets and returns on equity. Higher return figures generally indicate better investments. Although these return measures are not the only indicators of profitability that investors use, they are helpful—along with other decision-making aids—in evaluating investments.
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