CFA Practice Question

There are 534 practice questions for this study session.

CFA Practice Question

If a firm's asset turnover was to increase by 10% and the tax rate was to increase from 35% to 40%, leaving all other factors constant, the resultant change in the firm's ROE equals ______.
A. +1.5%
B. -1.9%
C. -1.1%
Explanation: ROE = Net income/Equity. Using the Extended DuPont System,
= (EBT/sales)*(sales/total assets)*(total assets/equity)*(1-tax rate).
The asset turnover ratio equals sales/total assets. Therefore, ROE(after)/ROE(before) = [asset turnover(after)/asset turnover(before)*]*[0.6/0.65] = 1.1*0.6/0.65 = 1.015. Thus, the ROE increases by 1.5%.

User Comment
galgan i do not agree. only relevant is change in tax rate. change in turnover of assets will result in same agregate change of profit margin and equity multiplier that will compensate asset turnover growth...
smiley25 has to increase therefore A is the only option
patsy galgan i think you need to read over the notes on the Dupont formula.
chamad Good point smiley. It's e nergy consuming. remarks such yours will save us calculations and time. Thanks
steved333 Yes, thanks (as long as we get the "only one option that fits" setup on the final!)
cong Pretty straightforward.
serboc if you don't know how to calculate ROE or fully understand it you are bound to fail
rhardin That's ridiculous serboc... there are 6 textbooks worth of material, and only about 150 questions on the test. So there will only be enough room for maybe 2 or 3 questions on ROE.
Allen88 Nice rhardin
Chebum Yeah serboc's a gimp...but none the less roe is important
Hishy I don't get why ROE increases. If Tax increases, doesn't NI go down, and therefore so does ROE?
Even if equity goes down as well because of reduced retained earnings, surely the % change in NI will be larger than the % change in equity...
jpducros Hishy, your reasoning is right but not complete. You forget that asset turnover increase by 10%. If this were the only change, then RoE would increase by 10%. Since tax is increasing, as you mentioned, this drives RoE in the opposite direction. Combined effect is +1,5%, as explained in the answer.
endurance You cant just imply that ROE increases, because the different ratios inside to ROE-formula works in opposite directions.

The tax ratio decreases ROE with 0.6/0.65 = 0.92
The asset turnover adds 1.1 - so the combined ratio increases with 1.0153 which is similar to a 1.5 percent increase.