Question

The DuPont formula defines the net return on shareholders’ equity as a function of thefollowing components:

• Operating margin

• Asset turnover

• Interest burden

• Financial leverage

• Income tax rate

Using only the data in Table 14.20:

a. Calculate each of the five components listed above for 2010 and 2013, andcalculate the return on equity (ROE) for 2010 and 2013, using all of the fivecomponents.

b. Briefly discuss the impact of the changes in asset turnover and financial leverage onthe change in ROE from 2010 to 2013.

Short answer

1. 11.9 and 13.6
2. Increased ROE

Step-by-step solution

Given information 

Income statement
Particulars	2010	2013
Revenues	$542	$979
Operating income	38	76
Depreciation and amortization	-3	-9
EBIT	35	67
Interest expense	-3	0
Pre-tax income	32	67
Taxes	-13	-37
Net income	19	30

Calculation of operating margin ‘a’

Operating margin = EBIT / Sales

For 2010 = $35 / $542 = 0.065

For 2013 =$67 / $979 = 0.068

Step 2: Calculation of Asset turnover

Asset turn-over = Sales / Total Assets

For 2010 = $542 / $245 = 2.21

For 2013 =$979 / $291 = 3.96

Calculation of Interest burden

Interest burden = Pre-tax profit / EBIT

For 2010 = $32 / $35 = 0.914

For 2013 =$67 / $67 = 1

Calculation of financial leverage

Financial leverage = Total Assets / Total Equity

For 2010 = $245 / $159 = 1.54

For 2013 =$291 / $220 = 1.32

Calculation of Income tax rate 

Income tax rate = Net income after tax / Pre-tax income

For 2010 = $13 / $32 = 40.63%

For 2013 =$37 / $67 = 55.22%

Explanation on impact of changes ‘b’

Using the DuPont formula:

ROE(2010) = (1 - .4063) x .9143 x .0645 x 2.2122 x 1.5409

= .119

=11.9%

ROE(2013)= (1 - .5522) x 1.0 x 0.684 x 3.3643 x 1.3227

= .136

= 13.6%

This implies that the asset turnover increased substantially over the period thus increasing the ROE.

This also implies that the financial leverage declined over the period thereby adversely affecting the ROE. Since asset turnover increased more than financial leverage declined the net effect was an increase in ROE.