When we are given the interest expense rate, we can use that number in the equation yet when we are given interest expense as a dollar amount, we need to divide it by total assets? Intuitively, I would have assumed debt would have been in the denominator. The question is, since when does interest expense dollars over total assets represent an interest expense rate? I understand that from an algebra standpoint assets need to be in the denominator but logically it is not jiving. From Schweser: Osnat Enterprise had the following financial data: Operating profit margin 10% Current ratio 2.5 Total asset turnover 2.4 Interest expense rate 6% Leverage multiplier 2.0 Tax retention rate 0.80 What is Osnat’s return on equity? A) 28.8%. B) 13.0% C) 14.4% D) 15.0% Your answer: A was correct! ROE = [(10% × 2.4) - 6%] × (2.0)(0.80) = 28.8% Thanks and I hope everyone is enjoying their day off from work as much as I am
Good question. Not sure if this helps, but try thinking of it this way: With the extended dupont equation you’re trying to account for the effect of financial leverage. The first part of the equation gives you operating profit (EBIT) as a percentage of total assets. You are now subtracting something from this. Something that accounts for interest expense. Since your profit is expressed as a percentage of total assets, one should be consistent and express interest as a percentage of total assets too. Not sure if that helps or not. Not the most technical of answers but tried to approach it intuitively. Good luck with your studies.
“one should be consistent and express interest as a percentage of total assets too” Thanks jabroni…I’ve noticed that understanding the deconstruction of ROE is the critical element in answering Dupont questions in lieu of memorization.