Modified/Alternate Du Pont

Composition

Prof. Shailesh Gandhi

IIM, Ahmedabad
Introduction
 Traditional Dupont decomposition does not
separate operating assets and liabilities from
financial assets and liabilities.
 Therefore, profitability comparisons for
companies with financial assets like large
cash holdings are difficult.
 Modified Dupont decomposition separates the
effects of financing cost, debt level, and cash
level, from operating performance.
Modified Financial Statements
 Step 1: Strip interest bearing debt from
current liabilities and LT liabilities. From the
total interest bearing debt, deduct cash to
arrive at net debt.
 Step 2: Determine working capital as current
assets (less cash) minus current liabilities
(less interest bearing debt).
 Step 3: Compute LT net operating assets =
LT assets minus other LT liabilities
Modified Financial Statements
(Contd.)
 Step 4: Compute modified Net Income = Net
income + Net interest exp after taxes
= (EBIT – Interest) * (1-t)
= EBIT * (1-t) – Interest*(1-t)
= NOPAT – Interest*(1-t)
Derivation
 ROE = (Net Income after Taxes) / Equity
 = (NOPAT – Interest Expense after Tax) / Equity
 = (NOPAT/Equity) – (IEAT/Equity)
 = (NOPAT/Assets) *(Assets/Equity) –
(IEAT/Debt)*(Debt/Equity)
 = Operating ROA * [(Equity+Debt)/Equity] -
(IEAT/Debt)*(Debt/Equity)
 = Operating ROA *(1+Debt/Equity) -
(IEAT/Debt)*(Debt/Equity)
 = Operating ROA + Debt/Equity * (Operating ROA –
IEAT/Debt)
 = Operating ROA + [Financial leverage ]*(spread)
Interpretation of Terms
 Operating ROA provides a measure of how profitably
the company deployed its operating assets to
generate operating profits.
 It can be further decomposed in to NOPAT margin (a
measure of profitability of a company’s sales from an
operational perspective) and operating asset turnover
(a measure of the extent to which a company was
able to use its operating assets to generate sales).
 Operating ROA = NOPAT/Sales * Sales/Net Assets
Interpretation (Contd.)
 Spread is the incremental ROE gain from
introducing debt into the capital structure. It is the
difference between the return on assets and the
cost of borrowing. There is a sweet spot for a
company between enough leverage and keeping
spread positive. Firms that do not earn adequate
operating returns to pay for interest cost reduce
their ROE by borrowing.
 A Firm’s spread times its net financial leverage
provides a measure of the financial leverage gain
to the shareholders.