Decision-making in entering new markets is a major concern for multinational corporations. If not taken into consideration it can lead to conflicts between the investors and their anticipated companies. Since profitability is the main objective of any company, there is a need to understand the methods of evaluating the profitability of investing in international trade. Therefore, this paper analyses two project evaluation methods: return on equity (ROE) and internal rate of return (IRR). Consequently, it outlines the advantages and disadvantages of each and hence provides ROE examples for two companies: Pfizer and Merck.
Return On Equity (ROE)
ROE is a method of estimating the amount that can be generated from a company’s assets. This amount is measured as a percentage, depicting the net income that can be realized from shareholders’ investments (McClure, 2010). For a company with an intention to invest in a foreign country, it is essential to use this project evaluation method so as to select the most profitable projects for international trade. Therefore, a company’s ROE is estimated by dividing the organization’s net income by the shareholder’s equity:
Return on Equity = Net Income/Shareholder’s Equity
According to Investopedia (2010), the net income is for the full financial year and shareholder’s equity ignores the preferred shares. Net income can be generated from the income statement and shareholder’s equity can be derived from the balance sheet (total assets minus total liabilities).
ROE enables international corporations to realize several advantages in regard to project selection. One benefit is that ROE is useful when comparing the profitability of companies that operate in the same industry. Price (1999) argues that knowing the ROE of a company helps investors to venture into profitable projects, since ROE depicts the amount of profit a company can generate given the stockholder’s investments. In addition, ROE is a signal for a company that is successful financially. It indicates whether a company is increasing its profit without expanding the equity capital. Therefore, ROE shows how investors’ capital is being managed and thus an increasing ROE indicates that shareholders are benefiting from the business operations (Staff, 2009).
However, ROE has some drawbacks. One of them is that ROE does not tell everything about the company to invest in. When the shareholders’ equity decreases, its value increases and therefore it is not an absolute indicator. More so, a high ROE does not elicit if a company has debts and that more money is actually generated from shares. Another issue with ROE is the way intangible assets are ignored in the shareholders’ equity. Aspects like brand names and trademarks are generally omitted from such calculations, leading to an understated value of shareholder equity. This creates a misleading ROE for investors (Maxipedia, 2009).
Internal Rate Of Return (IRR)
IRR is a discount rate at which the NPV (net present value) is zero for a sequence of upcoming cash flows (Anthens, 2003). This rate means that the present value or the cash inflow of the project would be equal to the present value of its cash outflows. Furthermore, IRR is seen as the break even discount rate. IRR like NPV takes into consideration the time value of money; it is categorized under the discounting methods of project evaluation and is mainly implemented through trial and error and financial spreadsheets. IRR is used to compare between two projects and the project with a higher IRR is preferable. Thus, a project with greater IRR than the expected rate of return is selected.
The benefits of IRR can be realized because it uses both the time value of money and the project’s cash flows. First, IRR is easy to calculate and use, thus giving investors an easy time to understand a feasible project. Second, IRR shows the return that can be realized from the initial capital invested in the project. This information is very useful for selecting projects to invest in oversees. However, IRR has some demerits. The main disadvantage with IRR method is that bogus rates of returns can be generated. Unrealistic IRR, say 30% may be an exceeding high rate for upcoming re-investments, thus misleading investors. Secondly, this method may generate many distinct IRRs. For instance, if there are two IRRs that make the current value of a venture equal to that of the initial venture, then a financial analyst will find it difficult to select between the two. Another disadvantage is that in case of mutually exclusive projects incorrect decisions may be followed. For instance, if accepting one project implies that another is rejected. The one having high IRR might not be having the highest NPV. Lastly, IRR is not necessary easy to calculate because of its unpredictable cash flows (Financial Modeling Guide, 2010).
ROE Calculations
This section analyses the ROE of two Pharmaceutical Companies in America: Pfizer and Merck. Using the following formula (all calculations are in millions):
- Return on Equity = Net Income/Shareholder’s Equity
The earnings (Net Income) for the Pfizer Inc. in 2009 were $8,635 (expressed in millions) (Pfizer, 2010). The average shareholder equity for the period is: [(Total equity for 06/2009 ($63,041)) + (Total equity for 09/2009 ($66,157))] Ă· 2 = $64,599 (Forbes, 2010). Thus using the formula for ROE, we have:
- $8,635 Ă· $64,599 = 0.1336 return on equity or 13.36%
The Net Income for Merck & Co Inc in 2009 was $3455.3 (Merck, 2009). The average shareholder equity for the period is: [(Total equity for 06/2009 ($12,035)) + (Total equity for 09/2009 ($12,900))] Ă· 2 = $12, 4675.5 (Forbes, 2010). Thus using the formula for ROE, we have:
- $3455.3 Ă· $12, 4675.5 = 0.2771 return on equity or 27.71%
From the above results, Merck’s ROE is higher that that of Pfizer. Hence, investors are likely to work with Merck.
References
Anthens, G. (2003). ROI Guide: Internal Rate of Return. Web.
Financial Modeling Guide. (2010). Capital Budgeting and the Pros and Cons of IRR and NPV. Web.
Forbes. (2010). Pfizer Inc (NYSE: PFE), Balance Sheet. Web.
Forbes. (2010). Merck & Co Inc New (NYSE: MRK), Balance Sheet. Web.
Investopedia. (2010). Return On Equity – ROE. Web.
Maxipedia. (2009). Return On Equity (ROE). Web.
McClure, B. (2010). Keep Your Eyes On The ROE. Web.
Merck & Co., Inc. 3Q 2009 Financial Results. Web.
Pfizer Inc. (2010). Pfizer Reports Fourth-Quarter and Full-Year 2009 Results; Provides 2010 Financial Guidance and 2012 Financial Targets. Web.
Price, J. (1999). Analysis – Return on Equity versus Return on Capital. Web.
Staff, M.F. (2009). Return on Equity: An Introduction. Web.