Question

The rise in the use of renewable fuels like ethanol had substantial impacts on states like North Dakota. The potential for these fuels is irrefutable. However, investment in renewables carries substantial business risk when federal mandates are not sufficient to mitigate risk. Imagine you are a member of the North Dakota State Legislator. You are faced with the choice of whether or not subsidies should be implemented across ND or not.

A. Explain how DuPont Analysis should be used to access farm performance in this case.

B. Create a mathematical framework that demonstrates how a subsidy which decreases the business risk may increase financial risk. ( Use the risk balancing hypothesis.)

C. Based on your analysis from part A and B what is your recommendation to the state?

Answer 1

1. A DuPont analysis is used to evaluate the components of a company's return on equity (ROE). It allows an investor to determine what financial activities are contributing the most in ROE. An investor can use analysis like this to compare the operational efficiency. Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed.
   ​DuPont Analysis=Net Profit Margin × AT ×EM

where:Net Profit Margin=Revenue/Net Income​

AT=Asset turnover ; Asset Turnover=Average Total Assets / Sales​ EM=Equity multiplier; Equity Multiplier=Average Shareholders’ EquityAverage / Total Assets​​

2. Risk balancing hypothesis states that change in business risk might produce opposite movement in financial risk . Business risk is measured as the volatility of rate of return on asset while financial risk refers to debt to equity ratio. Risk balancing Hypothesis shows that risk balancing might lead to failure of government policy in reducing risk and change in risk attitude or interest rate would lead to different adjustment in financial structure.

Financial risk and business risk are two different types of risks that investors must investigate when considering making an investment. Financial risk refers to a company's ability to manage its debt and financial leverage, while business risk refers to the company's ability to generate sufficient revenue to cover its operational expenses.

Financial risk is the risk that a company may default on its debt payments and business risk is the risk that the company will be unable to function as a profitable enterprise.

Year	Business Risk	Financial Risk	Movement in Business Risk	Movement in Financial Risk
1	0.30	0.35	-	-
2	0.40	0.30	0.10	(0.05)
3	0.30	0.41	(0.10)	0.11
4	0.25	0.60	(0.05)	0.19
5	0.20	1.00	(0.05)	0.40
6	0.40	0.80	0.20	(0.20)
7	0.60	0.70	0.20	(0.10)
8	0.70	0.50	0.10	(0.20)
9	1.60	0.30	0.90	(0.20)
10	1.70	0.20	0.10	(0.10)

3. Despite a maturing industry and a rapidly growing production , ethanol remains heavily subsidized. A handful of programs have comprised the bulk of the subsidies at the federal level. State support appears to be small in relation, though we were unable to properly characterize the many state and local credit subsidies frequently given to the industry.

While total government support for ethanol is not as high as total support for conventional fuels, the subsidy intensity metrics present a different picture. We expect that on a subsidy per unit of energy delivered basis that liquid biofuels would be close to the top for all energy sources.

We did not find a material difference in the subsidy intensity values when we estimated them., rather than an annualized estimate that incorporates the rapid pace of industry growth and the many new federal programs benefiting the sector but not yet funded.