Question (20 marks)

Suppose you are considering an investment in the common shares of NewTel Limited, a telecommunications company which delivered a return on common equity (ROCE) of 18.11% for the 2018 year. A sell-side analyst argues that this ROCE is a very strong result and well above the average return on Australian shares over the past 30 years (which is about 9% per annum), and therefore the company should be valued at a significant premium to book value. The analyst has also provided you with the following reformulated financial statements:

Reformulated 2018 income statement ($ millions):

Operating Income After Tax	36
Net Financial Income	7
Comprehensive Income	43

Reformulated balance sheet ($ millions):

	2018	2017
Operating Assets	175	131
Operating Liabilities	28	27
Net Operating Assets	147	104
Financial Assets	109	125
Financial Obligations	6	4
Net Financial Assets	103	121
Common Equity	250	225

Required:

(a) Decompose the firms ROCE into components representing operating profitability (RNOA), financial leverage and operating spread. Use the average of beginning and ending balance in calculations. (5 marks)

(b) On the basis of your answer to part (a) and without calculations, evaluate the companys profitability and the analysts statement regarding the companys valuation (i.e. its expected premium over book value). Specifically, discuss the drivers of the firms ROCE, whether you agree or disagree with the analyst about the strength of the firms profitability and why, and whether you agree or disagree with the analysts valuation and why. (8 marks)

(c) The analyst also claims that the company is likely either to pay a special dividend or to repurchase shares. Use your results from part (a) to show the effect on the firms ROCE of a $50 million special dividend, paid out of financial assets. (4 marks)

(d) Suppose that you are considering an alternative investment in the shares of Fresa Limited, a company that operates food stores. Would a decomposition of operating profitability into profit margin and asset turnover assist you in comparing NewTel with Fresa? Why or why not? (3 marks)