Use the DuPont equation to show how working capital policy can affect a firm’s expected ROE.

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Use the DuPont equation to show how working capital policy can affect a firm’s expected ROE.

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Use the DuPont equation to show how working capital policy can affect a firm’s expected ROE.

Explanation & AnswerSolution by a verified expert

Explanation

A firm's working capital policy affects its ROE differently depending on if the firm has a relaxed investment policy or a restrictive investment policy.
 
A firm with a relaxed investment policy maintains a large amount of current assets (cash, inventory, marketable securities) and a liberal credit policy which creates a high level of receivables.  This results in low asset turnover and therefore low ROE. A firm with this policy may seek higher profit margins to make up the difference.
 
A firm with a restrictive investment policy maintains a low level of current assets (cash, inventory, marketable securities).  This results in a high asset turnover and therefore a higher ROE. This is a higher risk strategy as the firm subjects itself to shortages and work stoppages.  A firm with this policy may emphasize high inventory turnover.

Verified Answer

The Dupont equation demonstrates how a firm's working capital management affects its return on equity as follows:
 
ROE = PM x Total Asset Turnover x Equity Multiplier
Example: ROE = .05 x .90 x 2 = .342 = 34.20%

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