Question One
DuPont Equation
The DuPont Equation describes return on equity using asset turnover, leverage and profit margin. By dividing ROE into three parts, one is able to understand the changes in equity over a particular period. A high profit margin and assets turnover increases ROE since the company is generating more sales. Increased leverage increases ROE because financing business operations using debt leads to high interest payments that are tax deductible. ROE = Net income/Sales * Sales/Total Assets * Total Assets/Average Shareholder Equity. In this case, ROE will be determined using net income and sales.
Profit Margin = 2.07% (0.0207)
Total Asset Turnover = 2.08
Return on Equity = 10.45%
DuPont Equation = 0.0207 (profit margin) * 2.08 (Asset turnover) *0.1045 (return on equity) = 0.0045
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Analysis and interpretation
The profit margin is used to determine how much a company is making in relation to sales. The margin also indicates the efficiency of marketing and cost control strategies. Since it is part of the DuPont equation, an increase in profit margin results to more money in a firm’s bottom line. Therefore, increased profit margin leads to higher return on equity. Based on the given data, the industry’s ROE is 21.00%, and that of Ski is 10.45%. The low ROE indicates that the Ski is not generating profit from its shareholders’ investment like its competitors in the industry. Ski’s profit margin is 2.07% while that of the industry is 3.50%, indicating that the company is not generating much profit from its sales. However, this could also be an indication of higher levels of debt. To improve the situation, the company should consider financing its operations using debt as this will increase ROE. Also, the management should find ways of reducing the cost of production to improve the profit margin. Overall, ROE is not a profitable company based on the performance in the industry.
Question Two
EVA (Economic Value Added)
EVA is calculated as follows: Net Operating Profit after Tax – (Capital Expenditure * WACC). Since the values needed to calculate EVA are not provided, the analysis will be made based on the ratios that best match the values required. The Net Profit after Tax will be represented by the profit margin since it shows how much profit the company is generating from the sales. The margin is calculated by dividing profit with sales. Capital expenditure will be represented by debt to asset ratio as this indicates the amount of assets that have been financed by debt. Capital expenditure can be money from investors or loans. WACC will be represented by return on equity since they both indicate the value he company is creating for investors. Therefore, EVA is calculated as follows:
EVA = 2.07 – (58.76 * 10.45) = -611.972.
Analysis and Interpretation
EVA represents the residual income after the cost of capital has been deducted. If the value is zero, this means the firms is at a breakeven point, where the profit generated covers the cost of capital, to both shareholders and lenders. If the value is greater than one, the firm is generating profit that is more than the invested capital. A positive value indicates that the company is creating value for the shareholders. In the current case study, Ski’s value is negative, which means the company is not creating value for the investors. The income generated does not cover the cost of capital; hence the company is not profitable.
Generating a higher EVA
To increases EVA, the company has to ensure that there is an increase in the profit margin in the DuPont Equation. To increase the profit margin, Ski has to decreases the cost of capital, or adjusts its marketing strategies to make more sales, which will increase the net income. Ski should enhance its leverage by financing its activities through debt. Debts attract interest payments, and these are tax deductible, hence reducing the cost of capital. Dividends are not tax deductible and a high amount of debt in capital increases ROE. However, an increase in debt will increase WACC since it increases the cost of equity due to increased risk. Ski can offset the increases in WACC by reducing the amount of risk. For instance, if the net income is low due to poor marketing strategies, the company can improve of marketing and reduce the risk. A reduction in risk will reduce the cost of capital, which in turn increases EVA.
