Question

Consider a firm with a net profit margin of 4.2%, a total asset turnover of 1.4, total assets of $40 million, and a book value of equity of 20 million.

What is the firm’s current ROE?

If the firm increased its net profit margin to 5%, what should be its ROE?

What would be the effect of buying back 5 million of equity with new debt? What would be its new ROE?

Answer 1

This is an application of Du Pont analysis, which breaks ROE into its constituent components to determine which of these components is most responsible for changes in ROE.

Mathematically,

ROE = Net Profit Margin * Asset Turnover ratio * Equity Multiplier

Where Equity Multiplier = Assets/Equity

No, in our question, if we substitute the values

Current ROE = 4.2% * 1.4 * (40/20) = 11.76%

Scenario 1: Now, assuming, net profit margin of company improves to 5%

ROE = 5% * 1.4 * (40/20) = 14%

Scenario 2: Now, assuming, company buys back $5 mil of equity using debt, the equity remaining = $15 mil (Assuming net profit margin stays at 4.2%)

ROE = 4.2% * 1.4 * (40/15) = 15.68%