Question

Decision A had a high ROA, but a low ROE. Decision B had a low ROA, but a high ROE. How do you decide in situations like this?

Is it possible that you could analyze a situation to find that it had a poor NPV, PI, IRR, and payback period, but still choose to go forward with the decision anyway?

Answer 1

If we go by the DU pont analysis formula

ROE = Net profit margin * Asset turnover ratio * Financial leverage

= (Net Income/ Sales)*(Sales/Total Assets)*(Total Assets/Total equity)

= Return on assets * Financial leverage

ROE = ROA * Financial Leverage

Now it is possible that the Decision A has high ROA but low ROE because of less financial leverage (less than 1), decision B has high ROE and low ROA becuase of high financial leverage (more than 1).

In these circumstances, it is up to the manager who is deciding whether he is willing to take financial leverage in his project, what is the economic outlook. Financial leverage magnifies the impact of return. So if there is financial leverage, then if economy is good then returns will be high but if things did not go well, it could also backfire the situation. Financial leverage is key determinant in this situation.

Yes, It is possible that company may go ahead with a project where the NPV, PI IRR and payback period is not favourable, like project related to legal rules and regulation, safety of employees, projects with social impact. These all projects do not have postive NPV or a definite payback period but since the organisation is operating in a society, it is it's obligation to work for the betterment of the society.