DuPont's 5 Step ROE

luutzu said:

Wondering if you guys could help clarify the use of DuPont's 5 step breakdown of ROE.

The 3 step is straight forward and i assumed the 5th is also until past couple weeks when i really look it over.

The aim, as i understand it, is to see the effect, both positive and negative, of leverage on earnings and hence return on equity.

But the breakdowns simply was to show the difference in earnings as 1. negatively affected by interest expense, and 2. positively as a reduction in tax expense.

That sounds good and straightforward until you take a closer look and see that it's based on the assumption that:
1. Earnings from sales will remain the same whether or not the company borrow;
2. That the impact of leverage is either an interest expense or a reduction in taxable income.

But that's wrong.

A company might not earn the same, or make the same amount of sales, if they do not use leverage [not borrow].
They could go broke if it weren't for borrowings...

So to assume their sales and earnings will be the same and that the only costs/benefits will be either interest expense or lower tax is flawed.
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Wouldn't an understanding of non/profitable use of debt be [following the same line of reasoning] the earnings if no debt were use vs when debt were used... then from that we can compare the impact of debt and see if it's worthwhile.

That could be better seen from other factors, not the ROE...

I've looked at a few text and not sure if i am too thick for DuPont.

thanks.

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craft said:

Not sure trying to torture the ’worthwhile use of debt’ answer out of dupont is appropriate. But that doesn’t mean the extra 2 steps don’t give insight.

Using EBIT rather than NPAT removes the financial structure influence from the profitability component which gives you a better economic insight and makes it much more usable for comparing across companies with different financial structures.

Isolating Interest/Assets a component is useful. It’s the jump of point to consider a company’s cost of debt and also how much leverage is not interest bearing.

In deciding the worthwhile use of debt question, you have to first answer the question, is the company's use of funded capital economically profitable, then you can look to the efficiency of the financial structure.

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