Question

You are preparing an equity research report focusing on Mattel (a major toy manufacturer). You identify the following from Mattel’s most recent financial statements.

Return on Equity (ROE)                          .12

Dividends                                               $288

Accounts Payable                                  $900

Average Days Payable                              33

Total Liabilities                                    $5,000

Retention Ratio                                      0.60

Profit Margin                                            .05

Tax Rate                                                   .24

a. Conduct a three-stage ROE Decomposition (DuPont Analysis) for Mattel

b. As you are explaining how to conduct the ROE Decomposition, your assistant asks, “Because increasing the equity multiplier will increase the return on equity (ROE), Mattel should attempt to maximize its equity multiplier.” Explain whether you would agree or disagree.

Answer 1

Before going into calculations, Some details of dupont analysis for return on equity are as under:

Purpose:	Du pont analysis is used to analyse the component / source of return of equity into three parts i.e profit margin, total asset turnover and leverage factor( financial leverage measured by equity multiplier) . It help investors and financial analysts to determine if a company is generting a return on shareholders equity then what is the actual source of that return i.e whether it is generating due to increase in profit margin or due to asset turnover or due to leverage factor. Means how the company generate return on equity. Here Return on equity=Net income/ Shareholder's equity.
	Where,Return of equity= (Net income/ Total sales)*( Total sales/ Total assets)*( Total Assets/ Shareholders Equity).
	Return of equity= (Profit Margin)*(Total asset Turnover)*( 1/ Shareholders Equity/Total Assets).
	Return of equity= (Profit Margin)*(Total asset Turnover)*( 1/ [Total assets- Total Debt]/[Total Assets]).
	Return of equity= (Profit Margin)*(Total asset Turnover)*( 1/ [1- [Total Debt]/[Total Assets]).
	Now breaking the return on equity helps to know profitability of company through profit margin ratio,efficiency in utilizing the assets of company through asset turnover ratio and level of leverage a company has through leverage factor
	Assuming all figures given in decimal points not in percentage terms in given question

Step by step calculation:

Step 1	Net Income calculation from retention ratio(NI)	0.6	=1-288/NI
	retention ratio'=total retained earnings / total net income'=(Net income - Dividend distributed)/net income	288/NI	=0.4
	'=1-(Dividend distributed/Net Income)	288/.4	=NI
		720	=NI
Step 2	Net Sales calculated from profit margin ratio(NS)	0.05	=720/ NS
	Profit Margin '= (Net profit/Net sales)'= Net Income/ Net sales	NS	=720/0.05
			=14400$
Step 3	Shareholder's equity from return on equity(SE)	0.12	=720/SE
	Return on Equity'=Net Income/ Shareholders equity	SE	=720/0.12
			6000$
Step 4	Now Shareholders Equity	'=Total Assets- Total Liabilities
	Total Assets from Shareholder's equity formula	= Total Liabilities+ Shareholder's equity
	( Note: Since in given question its mentioned total liabilities as 5000 so we are considering that total liabilities include account payable, loan payable, o/s expenses, fixed bonds, current liablities etc so account payable given in question is already a part of total liablities and not considered separately for liabilities)	=5000+6000
		=11000$
Step 5	Total asset turnover	=Total Sales/ Total Assets
	Efficiency in utilizing the assets of the company	=14400/11000
		=1.309091
Step 6	Total Asset / Shareholder's equity	=11000/6000
	Measure the level of leverage the company has through leverage factor. ( Equity Multiplier)	=1.83333
Step 7	Profit Margin( Given)	0.05
	This measures operating efficiency i.e profitability of the company
Step 8	As per Du pont analysis,
	Return of equity= (Net income/ Total sales)*( Total sales/ Total assets)*( Total Assets/ Shareholders Equity).	=0.05*1.309091*1.8333
		=0.12

Question  B:“Because increasing the equity multiplier will increase the return on equity (ROE), Mattel should attempt to maximize its equity multiplier.” Explain whether you would agree or disagree.

Solution B: We can partially agree that increasing the equity multiplier will increase the return on equity as it measures how much of the company's asset are financed by its own equity.i.e what is the debt burden that company currently has ? Usually we prefer a company should have low debt burden as high leverage would eat up the profit of the company in paying the debt and interest on loan and less amount left for reinvestment in business as profit for business expansion. This is more dangerous especially when the cost of financing via debt is high but high equity multiplier can also be preferred if high leverage is based on low cost of debt finance for assets on after tax basis and allow company to generate high return on equity i.e higher then debt financing cost by utilizing the assets in efficient way and generating higher profits to pay off its debt liabilities.

So as per dupont ananlysis , we should not only look at just equity multiplier as one factor for source of ROE. We should consider whether we can increase our ROE basis increasing the profit via reducing operating cost or increasing sales price or reducing the cost of good sold or due to lower tax rates.

We should also consider the efficiency in generating higher sales with lower amount of assets i.e efficiency in utilizing the assets. All factors- operating efficiency, asset utlization efficiency and leverage factor should be considered. Given statement in question above just focus on one point of dupont analysis with which we partially agree. So given statement is partial correct.