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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--------------------------------------