Strategic Finance Question 1

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STRATEGIC FINANCE 3

StrategicFinance

Question1

Accordingto Mckinsey, businesses would create more profit or value to theshareholders from return on invested capital (ROIC) than fromincreasing growth (Koller, Goedhart, and Wessels, (a), n.d., pp.655).When we consider a pharmaceutical company and an electric utilitycompany, the electric company would likely benefit more fromincreasing growth than from return on invested capital (ROIC) whilethe pharmaceutical corporation would likely benefit more from returnon invested capital (ROIC) than from increasing growth.

Thereason why pharmaceutical companies would benefit more from return oninvested capital than from return on increased growth is low cost ofproduction and barriers to entry like research and development cost,patent protection and so forth. This implies that as thepharmaceutical companies increases its return on invested capital(ROIC) it is likely to benefit from economies of scale (Koller,Goedhart, and Wessels, (a), n.d., pp.655). The factor of economies ofscale is prevalent here since it is the benefit that accrues to afirm due to increased production. Such benefit may include the lowcost of producing goods and services. Here, to gain from economies ofscale pharmaceutical companies may decide to increase their scale ofproduction, thus creating more value to both the shareholders and thecompany at large. The electric company would benefit from increasedgrowth since it is a monopoly and it is the only supplier ofelectricity.

Question2

Apharmaceuticals company could outperform an electric utility companyon all value drivers such as return on invested capital (ROIC) butstill deliver a lower total return to shareholders (TRS) on a numberof ways. It can outperform the electric company by producing in largescale so as to benefit from economies of scale such as low cost ofproduction. Another way they could outperform the electric utilitycompany is by reinvesting back into the business a percentage of thereturn on invested capital (ROIC) thus delivering low total return tothe shareholders (Koller, Goedhart, and Wessels, (b), n.d., pp.3-71).This implies that the common shareholders would receive less or alower total return. The pharmaceuticals company can also ensure thattheir required return or internal rate of return is high than thecost capital. This implies that the company will have a high returnon invested capital. Here, if the revenue growth does not generateprofit then it will not be able to create shareholder value or thetotal return to shareholders would be lower.

Question3

Acompany’s choice of inventory valuation method would likely affectits income, cash flows, and balance sheet. In inflationary periodsfor input prices, when a firm changes from First in First out (FIFO)to Last in First out (LIFO) inventory accounting, the earnings of thecompany would be lower than if it used the First in First out (FIFO)inventory valuation method. This is because the higher cost goodswould be accounted for in the cost of goods sold thus reducing theoverall income of the company (Investopedia.com, 2016). Since the netincome would be lower, the taxes would also be lower implying ahigher cash flow for the organization. However, in an inflationaryprice economy, LIFO would have higher COGS but at the same time, itwould represent the current economic reality. This implies thatprofitability would be more accurate and therefore a good indicatorof future profitability.

References

Koller,T., Goedhart, M., and Wessels, D. (a). Valuation: Measuring andManaging the Value of Companies, 6thEdition, pp. 655. Mckinsey &amp Company Inc. Retrieved on 20thAugust 2016.

Investopedia.com(2016). Effects of Inventory Valuation, Chapter 6-10. Retrieved on20thAugust 2016 fromhttp://www.investopediacom/exam-guide/cfa-level-1/assets/inventory-accounting.asp/

Koller,T., Goedhart, M., and Wessels, D. (b). Valuation: Measuring andManaging the Value of Companies, 4thEdition, pp.3-71. Mckinsey &amp Company Inc. Retrieved on 20thAugust 2016.

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