Most investors and analysts in the financial community observe the ROE closely.

Question

Most investors and analysts in the financial community observe the ROE closely. The ROE can be calculated simply by dividing net income by the snare holder's equity, and it can be subdivided into the key factors that drive the ROE Investors and analysts focus on these drivers to develop a dearer picture of what is happening in a company. An analyst gathered the following data and calculated the various terms of the DuPont equation for three companies: Referring to these data, which of the following conclusions will be true about the compan.es' ROEs? The main driver of company Cs superior ROE, as compared to that of company A s and company B's ROE, is Its greater use of debt The main driver of company A s inferior ROE. as compared to that of company B's and company Cs ROE, is its use of higher debt The main driver of company Cs superior ROE. as compared to that C company A's and company B's ROE, is its operate, efficiency.

Explanation / Answer

1) Answer (A) The main driver of company C's superior ROE, as compared to that of company A's and company B' ROE, is its greater use of debt financing.

Equity multiplier is nothing but a measure ment of company's financial leverage.Companies can finance purchase of assets either through debt or equity, So a high equity multiplier indicates that a larger portion of asset financing is being done through debt.

  Ex : company has a total assets of $10 million and stock holder's equity was $3 million,then the equity multiplier was 3.33, if stock holder't equity much reduced then debt would have increased and it shows as increment in equity multiplier. (10/2 = 5).

Since company A has very small equity multiplier compared to both B and C,The second option given was wrong and all the three companies have almost similar profit margin so that there was no operating efficiency difference between these 3 companies.

So that it is only because of Equity multiplier and company C which have a great equity multiplier among the three and which lead it to gain more ROE. (Since stock holder equity is less in case of company C which have a high equity multiplier it has more ROE by comparing to others which have similar Profit margin and Asset turnovers).

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