Question

You have recently taken a position as CFO of Elwood Electronics Inc., a leading manufacturer of consumer electronics. The industry is widely regarded as one of the more stable across the economic spectrum and offers good long-term growth prospects. In addition to Elwood Electronics Inc., there are several other well-capitalized competitors, and each company commands roughly identical market shares. Each competitor has highly efficient manufacturing processes and operates at virtually identical margins. In your new position as CFO, your incentive compensation plan is primarily driven by ROPI. Elwood Electronics Inc. has historically been ROPI neutral while its peers in have been ROPI positive.

a. Looking at the information below, what would be your immediate objectives for Elwood Electronics Inc. in order to drive positive ROPI. Explain your actions.

Elwood Electronics Industry Peers

Net operating profit margin (NOPM) 10.5% 10.5%

Working Capital as % of NOA 18.0% 13.5%

Debt to market value of equity (%) 2.0% 28.0%

Cost of Debt 3.0% 3.0%

Cost of Equity 8.0% 9.0%

Weighted average cost of capital (WACC) 9.5% 8.0%

Please answer!!!!

Answer 1

ROPI = NOPAT – (WACC × NOA),

Job of CFO is to favourably change the components of the ROPI equation so that Elwood Electronics generates positive ROPI. First, while increasing NOPAT can result in the desired outcome, the problem outlined an industry in which this looks to be challenging over the near-term. All competitors have identical market shares and margins, so Elwood Electronics would need to increase its sales by taking share from a strong field of competitors. While this will ultimately be the objective of executive management, as CFO we can take more immediate actions to increase ROPI.

Two ROPI drivers at Elwood Electronics appear out of balance relative to the company’s industry peers.

First, Elwood has 18% of its net operating assets tied up in working capital, compared to just 13.5% for the peers. By optimizing the supply chain at Elwood Electronics, the company can reduce its net operating asset base. This will result in a decreased “charge” against NOPAT in the ROPI equation due to decrease in NOA component.

Second, Elwood does not appear to be maximizing its capital structure relative to its peers. Total debt carried on the balance sheet can be increased to a reasonable level , which will decrease the WACC component in the ROPI equation. Again, this too will result in a smaller “charge” against NOPAT for ROPI calculation. However, Elwood Electronics should not experience a significant increase in its cost of equity due to this addition of reasonable leverage; at a 28% debt to cap level, Elwood Electronics would expect its cost of equity to mirror that of its close industry peers.

These two immediate measures can be adopted till a more thoughtful strategy of increasing sales and overcoming the competition is under formation.