True or False: An increase in the equity multiplier is always good for shareholders.

True

False

While investors are extremely interested in the return on equity (ROE), which is calculated as NetIncomeShareholderequityNetIncomeShareholderequity, looking at this figure does not tell the whole story. Instead, many investors and analysts look to the DuPont equation to study the components of ROE. The Dupont equation can be stated as:

ROE=ROAEquitymultiplierROE=ROAEquitymultiplier

Where ROA is the return on total assets.

However, given that ROA can be written as the product of profit margin and total assets turnover, the DuPont equation also implies that ROE can be stated as:

ROE=ProfitmarginTotalassetsturnoverEquitymultiplierROE=ProfitmarginTotalassetsturnoverEquitymultiplier

The profit margin indicates the income earned on company sales. Since this ratio is strongly influenced by costs and the price of sales, keeping costs in check while keeping prices at a premium will increase profit margin and increase ROE (all else equal).

Total assets turnover indicates how many times a companys assets were turned over in a given period of time (typically a year). Thus, this ratio represents the number of times the profit margin is earned.

The equity multiplier adjusts the return on assets (the product of profit margin and total assets turnover) upward to reflect the fact that interest had been paid to bondholders before net income to stockholders was calculated.

The ROE obtained by using the DuPont is the same as what would be obtained by the traditional method of dividing net income by shareholder equity. However, by breaking down ROE in this way using the DuPont equation, investors and analysts can gain further insights into the key drivers of ROE.

Use the previous passage of text to answer the question that follows.

Suppose a firm sees an decrease in the number of times its assets are turned over in a year.

This would represent a total assets turnover, resulting in a return on equity, all else equal.

According to the video, which of the following represents the ROE of a firm?

ROE=NetincomeSales+SalesTotalassets+TotalassetsCommonEquityROE=NetincomeSales+SalesTotalassets+TotalassetsCommonEquity

ROE=NetincomeSalesSalesTotalassetsTotalassetsCommonEquityROE=NetincomeSalesSalesTotalassetsTotalassetsCommonEquity

ROE=NetincomeSales+SalesTotalassetsTotalassetsCommonEquityROE=NetincomeSales+SalesTotalassetsTotalassetsCommonEquity

ROE=NetincomeSalesSalesTotalassets+TotalassetsCommonEquityROE=NetincomeSalesSalesTotalassets+TotalassetsCommonEquity

Use the table to match the mathematical expression with the correct component of the DuPont equation.

Expression	Profit Margin	Total Assets Turnover	Equity Multiplier
NetincomeSalesNetincomeSales
SalesTotalassetsSalesTotalassets
TotalassetsCommonEquityTotalassetsCommonEquity

Suppose that a firm has a profit margin of 3.00% and an equity multiplier of 1.5, with total sales of $100 million and total assets of $20 million.

Which of the following most closely approximates the firms ROE?

0.60%

0.16%

15.00%

22.50%

Step 3: Practice: DuPont and ROE

Now its time for you to practice what youve learned.

Suppose that a firm has a profit margin of 4.00% and an equity multiplier of 1.7, with total sales of $400 million and total assets of $80 million.

Which of the following most closely approximates the firms ROE?

20.00%

0.24%

34.00%

0.80%