[CFAI] – EOC of R34: Industry & Company Analysis

Question

[Hi,

Following are the two questions from EOC of chapter Industry & Company Analysis (Equity). i am unable to understand the explanation for the answers.  i am not putting the correct answers here so that everyone can solve the questions before the correct answer is given.

Que 1. The management of ABC Company must maintain a 40% debt-to-capital ratio. The company is currently highly profitable, but earnings are expected to decline by 2% each year for the next 6 years due to rising competition. If all earnings are to be retained for the next 6 years and the target debt-capital ratio will be maintained, which of the following is most likely over the period?
 
A. Total debt will increase. 
B. Total debt will decrease.
C. Total debt will remain the same.
 
my answer:
i think the answer us B. Total Debt will decrease. i did it using the equation for Debt to capital ratio = 0.40. taking total capital = $100 then debt = $40 and equity = $60 and increasing the equity over the next 6 years by 2% each year. that shows debt should decrease... I think i didn't take the correct approach to the question.

Que 2. A research analysts expects a company's PP&E to last for twice as long as what is implied in the company's current depreciation schedule. Therefore, she expects capital expenditure to significantly lower than depreciation for the next 5 years. Given that working capital and PP&E account for all the company's assets, if earnings and net working capital are expected to grow at a low single-digit rate during this period, which of the following is most likely?
 
A. ROIC will increase. 
B. ROIC will decrease.
C. ROIC will remain unchanged.
 
i am unable to make the head and tail of this question. i just can't understand what is said here and what we are supposed to do with it.

please kindly help with these questions.
Thankyou.

Maroon5 · Answer

Hey @sethneha‌, let me give this a go.

Que 1. My answer is A. If earnings are constant the next 6 years, which means that equity portion (and hence total capital will increase overall), to maintain the same debt to capital ratio the total debt has to increase as well.

Que 2. My answer is A. My reason is because net operating profit will increase since the rate of depreciation should be lower than expected hence ROIC should rise.

Are these correct?

sethneha · Answer

@Maroon5: yeah you are right, these are the explanations:

Que 1. Answer: A
 
Since the company is profitable and expects to retain all its earnings, equity and hence total
capital will increase over the 6-year period. In the line with the constant debt-capital ratio, debt levels will rise

Que 2. Answer: A
 
ROIC = NOPLAT / Invested capital
 
Working capital is expected to grow in line with earnings, which implies that ROIC will remain
stable. However, net PP&E is expected to decline because depreciation is expected to exceed capital expenditures. Therefore, total invested capital will grow at a slower rate than earnings, implying an improving ROIC.