Intermediate problem – Foundations of Financial Management #16 – Du Pont system of analysis Jerry Rice and Grain Stores has $4,000,000 in yearly sales. The firm earns 3.5 percent on each dollar of sales and turns over its assets 2.5 times per year. It has $100,000 in current liabilities and $300,000 in long-term liabilities. a. What is its return on stockholders’ equity? b. If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same as do current and long-term liabilities. 16. Solution Sales = $4,000,000 Profit margin = 3.5% Total asset turnover = 2.5 Current liabilities = $100,000 Long-term liabilities = $300,000 a. Calculation of the Total assets Total asset turnover = Sales / Total assets Total assets = Sales / Total asset turnover Total assets = $4,000,000 / 2.5 Total assets = $1,600,000 Calculation of the Return on assets Return on assets = Profit margin × Asset turnover Return on assets = 3.5% × 2.5 or 0.035 × 2.5 Return on assets = 0.0875 or 8.75% Calculation of the Total liabilities Total liabilities = Current liabilities + Long-term liabilities Total liabilities = $100,000 + 300,000 Total liabilities = $400,000 Its return on stockholder’s equity is: Return on equity = Return on assets / (1 – Debt / Assets) Return on equity = 0.0875 / (1 – $400,000 / 1,600,000) Return on equity = 0.0875 / (1 – 0.25) Return on equity = 0.0875 / 0.75 Return on equity = 0.1167 or 11.67% b. Total asset turnover = 3 Calculation of the new Return on assets Return on assets = Profit margin × Asset turnover Return on assets = 0.035 × 3 Return on assets = 0.105 or 10.5% Its return on stockholder’s equity will be: Return on equity = Return on assets / (1 – Debt / Assets) Return on equity = 0.105 / (1 – $400,000 / 1,600,000) Return on equity = 0.105 / (1 – 0.25) Return on equity = 0.105 / 0.75 Return on equity = 0.14 or 14%