Question

5. Assume you are decided to double for a sell-side analyst and you cover the widget industry. In 2018, Big Widget Company e manufacturing capacity by issuing debt in order to capitalize on the growing deman widgets. Assume that the company was oble to realize scole economies through increased buying wer. Any benefit from these scale economies was offset by borrowing money at a much higher interes e hon existing long term debt. Using 5-Stage DuPont ROE formulo, which of the following would be po least likely a. In 2018, NI / EBT (or the tax burden ratio) was almost the some as it was in 201:7 b. In 2018, EBT / EBIT (or the interest burden ratio) was higher than it was in 2017 c. In 2018, EBIT /Sales (or the operating margin) was higher as it was in 2017 d. In 2018, Sales /TA (or total osset turnover ratio) was higher thon it was in 2017 e. In 2018, ROE was glmest the some as it wos in 2017

Answer 1

Please note the two points:

• There was benefit of economies of scale, hence margins improved. Hence EBIT/Sales was definitely higher in 2018. Option (c) is very likely.
• Interest cost increased disproportionately because incremental borrowings were at higher interest rate. Hence, I / EBIT would be higher in 2018. Hence, interest burden ratio = EBT / EBIT = (EBIT - I) / EBIT = 1 - I / EBIT will be lower in 2018. Please read option (b) carefully. It says this ratio would be higher in 2018. Hence this option (b) is unlikely or least likely.
• Tax burden will remain the same. There is no reason why effective tax rate will undergo a change. Hence option (a) is very likely.
• Sales / Asset ratio may be higher or at best constant since capacity was doubled to meet the increase in demand. So, even option (d) is likely.
• In 5 stage Dupont analysis, some ratios were almost same, some increased and some decreased so ROE might have remained almost the same. Hence option (e) is also likely.

Thus based on facts given in the question and analysis of each of the option, we can safely say that option (b) is the least likely option.

Hence the correct answer is option (b).