Download Question: Marks: 10

Business Finance
Solution Assignment 01
Question:
Marks: 10
The following data is from Saratoga Farms Inc. 2004 financial statements.
Sales
Net Income
Total Assets
Debt to Total Asset Ration
=
=
=
=
$ 2,000,000
$ 200,000
$ 1,000,000
60
Required
a) Construct and solve the Dupont equation for Saratoga Farms.
b) What will be the impact on ROE if Debt to Total Assets Ratio were
20%?
Solution:
a) Dupont Equation
Dupont equation is used to judge the impact of operational efficiency and
effectiveness on the return on equity and assets or we can say on the overall
performance of the company. The Dupont equation can be obtained by
decomposing the ROE. It can be achieved through following way:
ROE
=
Net Income
-------------------Total Equity
Multiplying it by Assets / Assets (without changing anything)
ROE =
Net Income
Net Income Assets
---------------- = ---------------- x ----------Total Equity
Total Equity Assets
Net Income
Assets
ROE = --------------------- x ---------------Assets
Total Equity
Net Income
Assets
ROE = ---------------- x ---------------Assets
Total Equity
So, we have expressed ROE as a product of two other ratios – ROA and the equity
multiplier
ROE = ROA x Equity multiplier
= ROA x (1 + Debt-Equity ratio)
Now we will calculate the for the above date using Dupont Approach;
ROE = ROA x Equity Multiplier
ROE =
Net Income x
Net Sales
Net Sales
Assets
x
Assets
Equity
Business Finance
Solution Assignment 01
We can find equity by total debt to total assets ratio i.e. 60%. That means the
equity to assets is 40%. In Absolute values it is (1,000,000 x 0.40) = 400,000
So by putting the values in equation we may get,
ROE =
200,000
2,000,000
x
2,000,000
1,000,000
x
1,000,000
400,000
ROE = 0.50 or 50 %
b) Now if debt to total asset ratio is 20%
If debt to total assets ratio is 20% that means that now equity is 80% of the total
assets i.e. 800,000. The new ROE will be as follows:
ROE =
ROE =
Net Income x
Net Sales
200,000
2,000,000
x
Net Sales
Assets
x
Assets
Equity
2,000,000
1,000,000
x
1,000,000
800,000
ROE = 0.25 or 25 %
ROE will be decreased due to increase in equity.
---------------------------------------Best of Luck--------------------------------------