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Essentials Of Investments
Found in: Page 481
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

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.

  1. 11.9 and 13.6
  2. Increased ROE
See the step by step solution

Step by Step Solution

Step 1: 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

Step 2: 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

Step 3: Calculation of Interest burden

Interest burden = Pre-tax profit / EBIT

For 2010 = $32 / $35 = 0.914

For 2013 =$67 / $67 = 1

Step 4: Calculation of financial leverage

Financial leverage = Total Assets / Total Equity

For 2010 = $245 / $159 = 1.54

For 2013 =$291 / $220 = 1.32

Step 5: 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%

Step6 : 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.

Most popular questions for Business-studies Textbooks

Universal Auto is a large multinational corporation headquartered in the United States.

For segment reporting purposes, the company is engaged in two businesses: production of motor vehicles and information processing services.

The motor vehicle business is by far the larger of Universal’s two segments. It consists mainly of domestic United States passenger car production, but it also includes small truck manufacturing operations in the United States and passenger car production in other countries. This segment of Universal has had weak operating results for the past several years, including a large loss in 2012. Although the company does not reveal the operating results of its domestic passenger car segments, that part of Universal’s business is generally believed to be primarily responsible for the weak performance of its motor vehicle segment.

Idata, the information processing services segment of Universal, was started by Universal about 15 years ago. This business has shown strong, steady growth that has been entirely internal: No acquisitions have been made.

An excerpt from a research report on Universal prepared by Paul Adams, a CFA candidate, states: “Based on our assumption that Universal will be able to increase prices significantly on U.S. passenger cars in 2013, we project a multibillion-dollar profit improvement . . .”

a. Discuss the concept of an industrial life cycle by describing each of its four phases.

b. Identify where each of Universal’s two primary businesses—passenger cars and information processing—is in such a cycle.

c. Discuss how product pricing should differ between Universal’s two businesses, based on the location of each in the industrial life cycle.

Use the following case in answering Problems 29 – 32:

Mary Smith, a Level II CFA candidate, was recently hired for an analyst position at the Bank of Ireland. Her first assignment is to examine the competitive strategies employed by various French wineries.

Smith’s report identifies four wineries that are the major players in the French wine industry. The key characteristics of each are cited in Table 12.6. In the body of Smith’s report, she includes a discussion of the competitive structure of the French wine industry. She notes that over the past five years, the French wine industry has not responded to changing consumer tastes. Profit margins have declined steadily, and the number of firms representing the industry has decreased from 10 to 4. It appears that participants in the French wine industry must consolidate in order to survive.

Smith’s report notes that French consumers have strong bargaining power over the industry.

She supports this conclusion with five key points, which she labels “Bargaining Power of Buyers”:

  • Many consumers are drinking more beer than wine with meals and on social occasions.
  • Increasing sales over the Internet have allowed consumers to better research the wines, read opinions from other customers, and identify which producers have the best prices.
  • The French wine industry is consolidating and consists of only 4 wineries today compared to 10 wineries five years ago.
  • More than 65% of the business for the French wine industry consists of purchases from restaurants. Restaurants typically make purchases in bulk, buying four to five cases of wine at a time.
  • Land, where the soil is fertile enough to grow grapes necessary for the wine production process, is scarce in France.

After completing the first draft of her report, Smith takes it to her boss, RonVanDriesen, to review. VanDriesen tells her that he is a wine connoisseur himself and often makes purchases from the South Winery. Smith tells VanDriesen, “In my report, I have classified the South Winery as a stuck-in-the-middle firm. It tries to be a cost leader by selling its wine at a price that is slightly below the other firms, but it also tries to differentiate itself from its competitors by producing wine in bottles with curved necks, which increases its cost structure. The end result is that the South Winery’s profit margin gets squeezed from both sides.” VanDriesen replies, “I have met members of the management team from the South Winery at a couple of the wine conventions I have attended. I believe that the South Winery could succeed at following

both cost leadership and a differentiation strategy if its operations were separated into distinct operating units, with each unit pursuing a different competitive strategy.” Smith makes a note to do more research on generic competitive strategies to verify VanDriesen’s assertions before publishing the final draft of her report.

Smith notes in her report that the West Winery might differentiate its wine product on attributes that buyers perceive to be important. Which of the following attributes would be the most likely area of focus for the West Winery to create a differentiated product?

a. The method of delivery for the product

b. The price of the product

c. A focus on customers aged 30 to 45

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