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You are trying to estimate a growth rate for HipHop Inc
You are trying to estimate a growth rate for HipHop Inc., a record producer and distributor. The firm earned $100 million in after-tax operating income on capital invested of $800 million last year. In addition, the firm reported net capital expenditures of $25 million and an increase in noncash working capital of $15 million.
a. Assuming that the firm's return on capital and reinvestment rate remain un- changed, estimate the expected growth in operating income next year.
b. How would your answer to (a) change if you were told that the firm's return on capital next year will increase by 2.5%? (Next year's return on capital = This year's return on capital + 2.5%.)
Expert Solution
a. Computation of Expected Growth in Operating Income next year:
Return on Capital Employed (ROCE) = Net Income / Capital Invested
= $100 million/ $800 million
= 12.50%
Reinvestment Rate = (Net Capital Expenditure + Change in Noncash Working Capital) / EBIT*(1- t)
= ($25 millions + $15 millions)/ $100 millions
= 40%
Growth Rate = ROCE * Reinvestment Rate
= 12.50% * 40%
Growth Rate = 5%
So, Expected Growth in Operating Income next year is 5%.
b. Computation of Expected Growth in Operating Income next year if firm's return on capital next year will increase by 2.5%:
Next Year Return on Capital (ROC) = 12.50% +2.5% = 15%
Growth rate = ROC * Reinvestment rate
= 15% * 40%
= 6%
So, Growth rate will increase by 1%.
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