McKeown and Company currently has - An equity multiplier of 2.50, - A total asse
ID: 2798197 • Letter: M
Question
McKeown and Company currently has
- An equity multiplier of 2.50,
- A total asset turnover of 0.75,
- And a profit margin of 10%.
The president is unhappy with the current ROE (return on equity) and he thinks it could be doubled. He will accomplish this by:
- Increasing the profit margin to 12%
- And by increasing debt utilization
- However, total asset turnover will not change.
What should be the new equity multiplier and total debt ratio to double the return on equity? USE AT LEAST 4 DECIMAL PLACES
Explanation / Answer
WE KNOW THAT
AS PER DU PONT ANALYSIS
RETURN ON EQUITY = NET PROFIT MARGIN*ASSET TURNOVER*EQUITY MULTIPLIER
MOREOVER
NET PROFIT MARGIN = ((PROFIT AFTER TAX)/SALES)*100
ASSET TURNOVER = SALES / TOTAL ASSETS
EQUITY MULTIPLIER = TOTAL ASSETS / EQUITY
FOR INITIAL CASE
EQUITY MULTIPLIER = 2.50
TOTAL ASSET TURNOVER = 0.75
PROFIT MARGIN = 10%
HENCE
ROE = EM* TAT* PM =2.50*0.75*0.10= 0.1875
ASPER THE GIVEN CONDITION OF QUESTION
ROE IS DOUBLED
NEW ROE = 2* 0.1875 = 0.375
NOW PROFIT MARGIN = 12%
TOTAL ASSET TURNOVER =0.75
HENCE
ROE = EM*TAT*PM
0.375 =EM*0.75*0.12
EM= 4.1667
NOW
WE ALSO KNOW THAT
DEBT RATIO = 1-(1/EQUITY MULTIPLIER)
DEBT RATIO =1-(1/4.1667)
DEBT RATIO =0.7601