Question

Write an analysis in which you address the following: • Select two publicly-traded companies within the same industry and present the DuPont analysis for each of these companies. Explain how the debt has served to influence the ROE DuPont performance results for each, and then describe how volatility plays a role in the debt choices in the context of this DuPont analysis. • Consider each of the following capital structure theories: the tradeoff theory, the signaling theory, the debt financing to constrain the manager’s argument, and the pecking order hypothesis. Briefly describe each of these, and then order them in terms of which theory you believe to be most persuasive down to which you believe to be least persuasive. Form arguments defending your rankings and reference and discuss related academic studies to support your position.

Answer 1

Solution:

While analysing companies there are a lot of different methods that can be used. One of those methods is the DuPont Analysis. The DuPont Analysis is an extended analysis of a company’s return on equity. It states that a company can earn a high return on equity if it does three things. Those three things are: a) it has to have a high net profit margin, b) it has to use its assets effectively to generate more sales, and c) it has financial leverage. One thing to keep in mind when comparing two companies is to try and look at companies in the same industry. It is easy to see the differences between industries, and that may lead to misuse of The DuPont Analysis, and false assumptions being made. And when those assumptions determine where money should be invested that can create a problem.

For example, two companies in the computer business such Hewlett Packard, and Lenovo would be a good comparison.

Hewlett Packard

Hewlett Packard Inc. was created from a split up of Hewlett Packard Co and they focus on computers and computer accessories. As a result of that 60% of the company's revenue come from computers, and 40% comes from printers. This company is currently the number 1 company for printers in the world and the number one company for commercial PCs. Lenovo is the number 1 overall PC maker. The majority of HPs revenue comes from customers that reside in the US (HP Inc. Company Information, 2015). They also would rank in the Fortune 100 even though they were recently created by the breakup of HP, and HP Enterprise, the other company created by the spilt off, would also rank in the Fortune 100. This is a company that in many ways is still finding their feet because they were part of a much larger corporation and now they are their own company focusing on computers and printers. This is an example of a company that has the capability to grow if the company decides to.

DuPont Analysis of Hewlett Packard

	ROE =	ROA x	Leverage
Oct 31, 2015	16.4%	4.26%	3.8
Oct 31, 2014	18.75%	4.86%	3.86
Oct 31, 2013	18.75%	4.84%	3.86
Oct 31, 2012	-56.38%	-11.63%	4.85
Oct 31, 2011	18.31%	5.46%	3.35

For Hewlett Packard the decrease in Return on Equity (ROE) for 2015 can be directly connected to the decrease in Return on Assets (ROA) which will be shown in the chart below. The following chart will also show that the asset turnover for 2015 was down as well. What this tells an investor is that the company is not turning their resources into a product that is sold as regularly. This could be a reflection of a decrease in demand for the product or an increase in resources being purchased because of an expected increase in demand (HP Company Information, 2015)

	ROE =	Net Profit Margin x	Asset Turnover x	Leverage
Oct 31, 2015	16.4%	4.41%	0.97	3.85
Oct 31, 2014	18.75%	4.50%	1.08	3.86
Oct 31, 2013	18.75%	4.55%	1.06	3.86
Oct 31, 2012	-56.38%	-10.51%	1.11	4.85
Oct 31, 2011	18.31%	5.56%	0.98	3.35

Lenovo

Lenovo first started off as a company named Legend Holdings in China with approximately the equivalent of $25,000 of US currency. In 1988 the company was incorporated in Hong Kong and became the largest PC company in China. In 2004 the name was changed to Lenovo and in 2005 they acquired the personal computer division of IBM. Today Lenovo is $34 billion personal technology company and the world’s largest computer vendor. However, they are much more than a PC company as they offer a full range of personal technology products including smartphones, tablets and smart TVs. Currently Lenovo is the fourth largest smartphone company and the number 3 company in the world for smart connected devices (About Lenovo, 2015).

Their company is trying to create a PC+ era were they are creating new categories of products that enhance the customer experience and differentiate them from their competition. Lenovo expands globally, we are establishing even deeper roots in each major market, investing not only in sales and distribution, but also in local domestic manufacturing, R&D and other high-value functions. This global reach with local excellence is enabling us to build a new kind of company – a “global-local” company and positions us to more deeply implement our protect and attack strategy and build the foundation for long-term success. Lenovo has consistently outgrown the worldwide PC market in unit shipments and gained market share across all geographies, products end customer segments, making it the fastest growing major PC Company in the world for three years running (About Lenovo, 2015).

DuPont Analysis of Lenovo

Data Indicators	2014	2015
Net profit ratio of equity	6.21%	5.68%
Asset net profit ratio	3.01%	3.46%
Equity multiplicator	2.06	1.87
Asset turnover rate	53%	60%
Main business net profit	4,493,451	4,931,286
Net profit	4,493,451	4,931,286
Main business income	79,087,124	87,048,831
Asset debt ratio	51.39%	46.51%
Cost amount	72,823,086	80,078,255
Main business cost	36,488,433	41,063,184
Operating Cost	24,138,337	26,174,190
Management cost	10,500,241	11,741,560
Financial cost	1,696,075	1,099,321
Asset amount	149,038,395	142,629,989
Liquid assets	17,246,183	15,275,757
Currency asset	5,317,489	5,754,033
Short-term investment	0	0
Account	5,229,980	4,548,429
Inventory	3,114,632	2,107,812
Other liquid	3,548,082	2,865,483
Long-term assets	131,792,212	127,354,232
Long-term investment	0	0
Fixed assets	118,492,120	116,056,432
Intangible assets	3,136,557	3,143,983
Other assets	10,163,535	8,153,817

Lenovo Is a company that has not been established as long, and has not been a publicly traded company for as long as Hewlett Packard which led to some more limited Information. However the information that was found showed that Lenovo is showing remarkable growth. The Return on assets however is low similar to Hewlett Packard because of the way that the computer industry operates. This is why it is so important to compare companies in similar industries to be able to tell where a company many stands. Overall Lenovo has not had the struggles that Hewlett Packard has had partially because they have such a strong base, and they sell more variation of products (About Lenovo, 2015).

Capital Structure Theories

Capital Structure is a combination of sources of funds in which we can include two main sources proportion. Those two sources are capital and debt. There are four of these theories which are the trade-off theory, the signalling theory, the debt financing to constrain managers argument, and the pecking order hypothesis. Each of those theories explain the effect of changing the proportion of capital and debt.

The trade-off theory refers to the idea that a company looks at the costs and benefits of debt finance and equity finance before determining what method should be used to finance a project. In this method a company essentially looks at the benefits of debts and weighs them against the cost of those same debts. The benefits to debt include the tax advantages that the company experiences while the costs include the cost of paying back that debt since there is an interest amount set. These two factors must be considered closely when looking at how to finance any project because ultimately all projects are financed as a combination of debt and equity, and the portion of each that is used for a particular project can determine how good a project can turn out to be for the company.

The signalling theory is more based on the signal that a company is showing to its investors based on the products or services that it provides. Essentially under the signalling theory a company that is diverse sends better signals to the outside users and therefore reflects well on the company. One reason for this is a company that is diverse generally has less problems if one of their products starts to not do as well as it has in the past. The downside could also be that the company is in so many different products that they are not really considered the best at any particular product. They become a jack of all trades and master of none.

Using debt financing to constrain managers refers to the fact that a company can constrain what managers do by financing projects with debt. This means that organisations purposely finance projects with debt because it makes their managers look at how the money is being spent, and analyse it closer. The theory is that if managers have assets to finance a project they will finance a project more freely if they do not have to deal with debt and the cost of that debt. Managers realise that they do in fact answer to investors and because of those answers that they have to provide the managers will look at it differently when debt is involved.

The pecking order hypothesis states that the cost of financing is directly affected by asymmetric information. Under this theory there are three sources of financing which are internal funds, debt and new equity. In this theory companies will use internal financing first, then debt, and finally new equity as a last resort. Internal financing is preferred because there is no additional cost to affect the decision. The debt is used next because it is more favourable then selling new equity. One reason that equity is used last is that the investors will believe that the managers of the organisation believe that their company is overvalued and for that reason is trying to take advantage of that fact when they sell new equity.