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d)      Profitability

 

Ultimately, you will have to analyze whether the investments that you have been undertaking are profitable enough, i.e. whether they are sufficient to satisfy all the investors of the company (both the shareholders and the debtholders). In order to address this point, we will need to introduce the notions of Return On Equity (ROE), Cost of Equity (CE), Return On Capital Employed (ROCE) and WACC (Weighted Average Cost of Capital).

 

Return On Equity (ROE): the return on equity for the year N is given as the net income realized for this period divided by the book value of equity at the beginning of the period. This represents the return on the money which has been invested by the shareholders of the company (after corporate tax but before personal income tax).

 

N.B: The reason why we are specifying that we shall work with the book value of equity is that it may happen that the company is floated on the stock market (which is not really the focus of this program, which is essentially designed for young entrepreneurs).

In this case, the market value of shareholders’ equity may not be equal to the book value of equity. Despite this fact, ROE is always computed using the book value of equity; a vague reason for this is that the market value of equity already reflects the anticipated growth of the company, and therefore does not truly reflect the return realized on the funds brought by the shareholders for the current period. However, note that the accounting concept of ROE is not completely satisfactory either, for exactly the same reason: if shareholders were to sell their shares of the company now, they would sell them on the basis of the market price (not on that of the accounting value of equity).

 

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