Analysts and investors often use return on equity (ROE) to compare profitability of a company with other firms in the industry. ROE is considered a very important measure, and managers strive to make the company's ROE numbers look good.
An increase in 'ROE would imply an increase in shareholder wealth.
Based on your understanding of the uses and limitations of ROE, which of the following projects will a manager likely choose if his or her bonus is solely based on the ROE of the next project?
a. Project X, with 35% ROE and a large investment, generating high expected cash flows.
b. Project Y, with 40% ROE and a small investment, generating low expected cash flows.
Suppose you are trying to decide whether to invest in a company that generates a high expected ROE, and you want to conduct further analysis on the company's performance. If you wanted to conduct a trend analysis, you would:
a. Analyze the firm's financial ratios over time
b. Compare the firm's financial ratios with other firms in the industry for a particular year
You decide also to conduct a qualitative analysis based on the factors summarized by the American Association of Individual Investors (AAII). According to your understanding, a company with less competition is considered to be risky than companies with multiple competitors.
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