Question

7. DuPont Identity. X Corp. has net income of $20 million, Sales of $100 million, asset turnover of .6, and debt-equity ratio of 40%. a. What is its return on equity? b. If X increases its debt-equity ratio to 60%, what happens to its return on equity?

Answer 1

Step-by-step explanation:

Net Income = 20m

Sales = 100m

Debt-equity ration = 40%

Asset turnover = 0.60

A)

Profit Margin = Net Income / Sales = $20 million / $100 million = 20%

Equity Multiplier = 1 + Debt-Equity Ratio = 1 + 0.40 = 1.40

Return on Equity = Profit Margin * Asset Turnover * Equity Multiplier = 20% * 0.60 * 1.40 = 16.80%

B)

Debt-equity ratio = 60%

Equity Multiplier = 1 + Debt-Equity Ratio = 1 + 0.60 = 1.60

Return on Equity = Profit Margin * Asset Turnover * Equity Multiplier = 20% * 0.60 * 1.60 = 19.20%

As calculations provide, if debt-equity ratio increases to 60%, Return on equity will increase by 2.40% (19.20% - 16.80%)