CFA Practice Question
Orion Manufacturing has a retention ratio of 70%. Its net margin is 7.8% of sales with an asset turnover of 1.2. Orion is fairly conservative in its capital structure with debt representing only 20% of equity. What is the projected growth rate for Orion's earnings and dividends?
A. 5.46%
B. 6.55%
C. 7.86%
Explanation: This is solved in two steps. First we calculate the ROE and then the growth rate.
We use the DuPont formula to project the ROE. Asset to equity ratio can be deduced from debt to equity ratio. Since debt-equity is 0.2:1, total capital is 1.2 for every unit of equity. Thus Assets/Equity = 1.2, because total assets equal total capital on the balance sheet.
ROE = 0.078 x 1.2 x 1.2 = 0.1123, or 11.23%
Growth rate = Retention ratio x ROE = 0.70 x 11.23 = 7.86%
We use the DuPont formula to project the ROE. Asset to equity ratio can be deduced from debt to equity ratio. Since debt-equity is 0.2:1, total capital is 1.2 for every unit of equity. Thus Assets/Equity = 1.2, because total assets equal total capital on the balance sheet.
ROE = 0.078 x 1.2 x 1.2 = 0.1123, or 11.23%
Growth rate = Retention ratio x ROE = 0.70 x 11.23 = 7.86%
User Contributed Comments 11
| User | Comment |
|---|---|
| dimos | I still believe that Assets/Equity = 1/1.2 = 0.8333!!!! I mean I dont understand why total capital/equity is 1.2!!! CAN ANYONE HELP? |
| Carol1 | do u believe assest can be less than equity, if it is 1/1.2? |
| chenchow | Asset = Equity + Debt |
| jayjunk | The net margin of 7.8% is after interest paid, so entire 7.8% goes to equity. |
| dimanyc | D/E=(TA-E)/E=TA/E-1=0.20 Therefore, TA/E=1.20 |
| steved333 | if debt is 1 part, which is 20% of equity, equity must be 5 parts. 1+5=6. If Assets=6 and Equity=5, then A/E=6/5, or 1.2. Multiply by 1.2 and 7.8 times retention, and you get 7.86240. |
| Dinosaur | dupont |
| djread | quick conversion of D/E ratio into debt/total capital ratio = [(D/E)/1+(D/E)] |
| jpducros | learn steved333 method, you may save a lot of time. djread, your formula works but what you need here is not D/A but A/Eq |
| tommyguard3 | very simply, debt + equity = assets. Therefore if debt/equity = 0.2/1, then debt = 0.2 and equity = 1. assets = 0.2+1 = 1.2. assets/Equity = 1.2/1 = 1.2 |
| seon | Debt/Equity = 0,2 -> Equity = 5 x Debt Total Assets = Debt + Equity = 1 x Debt + 5x Debt -> can be divided in 6/6. 5/6 is equity and 1/6 is debt. Total Assets = 1:(5/6) = 1,2 |