Suppose that youre comparing two companies in the same industry that are the same in every way except their profitability.

Company A Company B

Shareholders Equity $100m $100m

Invested Capital $100m $100m

Return On Equity 12% 4%

Cost of Equity 8% 8%

1. Begin with a simple comparison:

Value each of these companies assuming that the ROEs provided above are sustainable, and that both companies have a sustainable growth rate = 0%.

1. What is the value of Company A using these assumptions?

2. What is the value of Company B using these assumptions?

3. Explain why one of these companies appears to be so much more valuable than the others.

2. Now explore how each of these companies would be affected by growth:

Value each of these companies assuming that the ROEs provided above are sustainable, and that both companies have a sustainable growth rate = 5%.

1. What is the value of Company A using these assumptions?

2. What is the value of Company B using these assumptions?

3. What does this tell us about which of these companies should be reinvesting its cash flow in order to grow?