Dupont Question

From q-bank: With other variables remaining constant, if profit margin rises, ROE will: A) fall. B) remain the same. C) increase. D) initially fall and then increase. Your answer: B was incorrect. The correct answer was C) increase. I’m not sure I agree with this. If you take the dupont ratio: ROE = ROA x financial leverage = (net income/revs) x (revs/assets) x (assets/equity) you can easily see that if profit margins go up, net income goes up so ROE goes up. My question is that shouldn’t equity increase by the increase in net income from the increase in profit margins? This would offset the increase in net income make the ROE stay the same.

i think you maybe are overthinking this one… ROE = Net Profit Margin * Asset Turnover * Financial Leverage its assumes asset turnover and financial leverage stay constant (assume 1 each for simplicity) so… ROE = Net Profit Margin * 1 * 1 Therefore if profit margin increases - ROE will increase It also doesn’t say that NI goes up, sales may have fallen, which would also increase that ratio…

tmackenz hit it on the head.

that means the answer of the Q-bank is wrong?!

In economics you have to be very careful not to overthink things. Most relationships at intro level of economics are “ceterus peribus” which translates to holding all else constant I believe. So ya just make sure you don’t overthink things when not required to. This question clearly states holding all else constant. Profit margin goes up then ROE goes up.