PRAT Model - Issuing New Equity and its impact on Dupont Model

CFA Level II Equities
#1

Can someone kindly explain how issuing new equity impacts on the Dupont equation with respect to the PRAT Model?

Thanks!

#2

Lowers leverage, and increases asset account (cash) through equity issuance, which causes ROE to fall.

#3

Thanks dailygrind. I would agree with that too, which is precisely why I’m puzzled why the schweser text says:-

“If the actual growth rate is forecasted to be greater than the Sustainable Growth Rate (SGR), the firm will have to issue equity unless the firm increases its retention ratio, profit margin, total asset turnover, or leverage”.

SGR = retention ratio x ROE;

and then ROE = [net income/sales] x [sales/total sales] x [total assets/equity]

Thus if the actual growth is forecasted to be > SGR, how does issuing new equity help to bring(increase) the SGR up to match the forecasted higher growth, if in fact issuing it Decreases ROE?

Can someone kindly help to explain this in light of the above please?

#4

i don’t think your logic is correct. “Thus if the actual growth is forecasted to be > SGR” , “how does issuing new equity help to bring(increase) the SGR up to match the forecasted higher growth”

Issuance of new equity will not affect SGR (which is affected only by RR and ROE). Also, one of the assumptions behind SGR is that capital structure is not changed - which it would if you issue new equity.

The idea here is that to grow (earnings/revenue etc.) you have to invest money in the company which is where the SGR comes in. If retained earnings are insufficient, you can grow by (1) borrowing money above that implied by the capital structure or (2) issue new equity.

#5

Thanks CMLSML!