Attempts Do No Harm: 14 9. DuPont equation AaAa Corporate decision makers and an

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Attempts Do No Harm: 14 9. DuPont equation AaAa Corporate decision makers and analysts often use a particular technique, called a DuPont analysis, to better understand the factors that drive a company's financial performance, as reflected by its return on equity (ROE). By using the DuPont equation, which disaggregates the ROE into three components, analysts can see why a company's ROE may have changed for the better or worse, and identify particular company strengths and weaknesses. The DuPont Equation A DuPont analysis is conducted using the DuPont equation, which helps to identify and analyze three important factors that drive a company's ROE. Complete the following equations, which are needed to conduct a DuPont analysis: Profit Marginx x Total Assets Turnoverx ROE = Total Assets Total Common Equity Sales Total Assets Most investors and analysts in the financial community pay particular attention to a company's ROE. The ROE can be calculated simply by dividing a firm's net income by the firm's shareholder'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 clearer picture of what is happening within a company. An analyst gathered the following data and calculated the various terms of the DuPont equation for three companies:

Explanation / Answer

Question - 1

Question - 2 .......... (b)

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

A higher leverage with favorable conditions will have multiplier effect in maximizing the ROE. Debt is always paid a fixed interest. As such in favorable conditions out of huge profits only a fixed part is paid to debt and remaining profits shall belong to comparatively lower equity, thus increases ROE.

ROE = Profit Margin X Total assets turnover X Euquity Multiplier = Net Margin X Sales X Total assets Sales Total assets Total common equity

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