Question

If a firm's profit margin increases by 8%, the debt-to-equity ratio increases from 35% to 55%, and asset turnover falls by 20%, the effect on ROE is ______.

A. +1.6%

B . +0.24%

C . -0.8%

If a firm's profit margin increases by 8%, the debt-to-equity ratio increases from 35% to 55%, and asset turnover falls by 20%, the effect on ROE is ______.

A. +1.6%

B . +0.24%

C . -0.8%

Which of the following financial ratios is NOT used in determining a company's return on equity with the extended DuPont model?

A. Total asset turnover

B . Total debt ratio

C . Operating profit margin

D . Interest expense rate

Answer 1

Suppose Profit margin = 5%

Assets turnover = 1

Debt equity ratio = 35%

Equity multiplier = 1.54

Return on equity is calculated below using Du Pont Formula:

Return on equity = Equity Multiplier × Assets turnover × Profit margin

                            = 1.6 × 1.0 × 5%

                            = 8%

Return on equity is 8%

Now,

If a firm's profit margin increases by 8%, the debt-to-equity ratio increases from 35% to 55%, and asset turnover falls by 20%.

Profit margin = 5% × (1 + 8%)

= 5.40%

Assets turnover = 0.8

Debt equity ratio = 55%

Equity multiplier = 2.22

Return on equity is calculated below using Du Pont Formula:

Return on equity = Equity Multiplier × Assets turnover × Profit margin

                            = 2.22 × 0.8 × 5.40%

                            = 9.60%%

Return on equity is 9.6%

Return on equity increase by 1.60%.

Option (A) is correct answer.

3.

Interest expense rate is NOT used in determining a company's return on equity with the extended DuPont model.

Option (C) is correct answer.

Asset turnover falls by 20%