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.  Use no more than 50 words.

Answer 1

1) Return of Equity = .12 or 12% | Retention Ratio = 60% | Dividends = 288 | Profit Margin = 24%

Using Retention ratio, we can find Dividend Payout ratio.

Dividend Payout = 1 - Retention ratio = 1 - 60% = 40%

Dividends = Dividend Payout * Net Income

=> 288 = 40% * Net Income

=> Net Income = 288 / 40% = 720

We know the Profit margin, hence, we can find Sales.

Profit Margin = Net Income / Sales

Sales = Net Income / Profit Margin

Sales = 720 / 24% = 3,000

Now we will conduct 3-stage decomposition of ROE

ROE = Net Income / Equity

Dividing and multiplying RHS with Sales

ROE = Net Income / Sales * Sales / Equity

Dividing and multiplying RHS with Assets

ROE = Net Income / Sales * Sales / Assets * Assets / Equity

Net Income / Sales = Profit Margin | Sales / Assets = Assets Turnover | Assets / Equity = Equity Multiplier

As we already know ROE, we can find Equity and then Assets using the ROE Dupont formula.

ROE = Profit Margin * Sales / Equity

12% = 24% * 3,000 / Equity

Equity = 24% * 3000 / 12% = 6,000

We already know the Total Liabilities = 5,000

Assets = Liabilities + Equity

Total Assests = 5,000 + 6,000 = 11,000

Hence, Asset Turnover = Sales / Assets = 3000 / 11000 = 0.27

Equity Multiplier = Assets / Equity = 1.83

Final ROE 3-Stage decomposition

ROE = Profit Margin * Assets Turnover * Equity multiplier

ROE = 24% * 0.27 * 1.83 = 12%

2) As per ROE decomposition, it depends on Profitability, efficiency in usings its assets and Financial leverage. If we try to maximize Equity multiplier, it will definitely increase ROE, however, it increases financial risk which makes it undesirable to investors. Hence, I would disagree on maximizing the Equity multiplier for increasing ROE. Instead, companies should concentrate on increasing their Profit margin and Asset utilization efficiency while keeping Equity multiplier at an optimum level which will increase company's ROE without increasing its Financial risk.