Question

1. You heard on the internet that the CEO of Boeing got a huge bonus because the firm’s return on equity (net income/equity) increased. Does this make sense to you?

2. What is implied by the fact that a firm’s equity multiplier increased while the firm’s ROE was constant?

3. What is implied by the fact that a firm’s return on assets increased while their profit margin decreased?

4. What ratios would you examine to explain why a firm’s operating margin decreased (be as specific as possible)? 4

5. In your opinion, what is the single most relevant traditional based performance measure (consider all of the ratios provided on the PDF document entitled “DuPont Ratios”)? Explain your selection!

6. In 2019, a firm issued a significant amount of debt (bonds) and repurchased their equity (stock) with the funds raised from the debt offering (a debt for equity swap). The objective of this dramatic increase in leverage was to lower the firm’s WACC. Their analysis suggests that the firm’s WACC will decrease from 8% to 6% due to this debt for equity swap. Based on the Dupont model, how would this change in capital structure impact the firm’s future performance (profitability)? Does your response change if you use operating income versus net income to complete the Dupont analysis?

7. What are the similarities and the differences between the following two performance measures: Operating Margin and Profit Margin?

Answer 1

1. Return on equity is the key ratio which shows the returns received by the shareholders on their money invested in buying the equity of the firm. Higher ROE, without any decrease in the equity base, is a positive thing and implies that the profitability of the company has improved. In such a case, rewarding a CEO with higher bonus is not surprising. However, we need to know the exact reason for rise in ROE, higher net income or lower equity base.

2. Du-pont ROE model:

ROE = [Net Income / Sales] x [Sales / Average Total Assets] x [Average Total Assets / Average Shareholder’s Equity]

i.e. ROE = Net Profit Margin x Total Assets Turnover Ratio x Equity Multiplier (or Financial leverage ratio)

If ROE is constant while equity multiplier has increased, then it implies that either the net profit margin or the Total assets turnover ratio has decreased.   

3. Lower profit margin along with an increase in the ROA implies that the assets have decreased. This is turn implies that the company is now utilising the assets more efficiently as ROA has increased.