If Company A and Company B have identical operating profit margins and identical asset turnover, but Company A has a higher financial leverage ratio (Equity Multiplier), what will be the effect on Company A's Return on Equity (ROE)?

[ A ]Company A will report a higher ROE, but will also carry higher financial risk and earnings volatility due to debt servicing obligations.[ CORRECT ]

[ B ]Company A's ROE will be strictly lower than Company B.

[ C ]Company A's ROE will be completely unaffected by its financial leverage.

[ D ]Company A will be legally prohibited from distributing dividends to shareholders.

Takeaway

Company A will report a higher ROE than Company B due to its greater financial leverage, but that higher ROE comes with correspondingly higher financial risk and earnings volatility from debt-servicing obligations.

Derivation

In the DuPont identity, ROE = Net Margin x Asset Turnover x Equity Multiplier (Leverage); since margin and turnover are identical between the two companies, the entire ROE gap is explained by the leverage term — a higher Equity Multiplier mechanically produces a higher ROE by shrinking the equity base the same net income is divided over. But this leverage-driven boost is not a free lunch: Company A must service more fixed interest obligations regardless of how operating performance fluctuates, meaning its earnings (and by extension ROE itself) will swing more violently in both good and bad years than Company B's. This 'leverage amplifies both returns and risk' insight is the core lesson the DuPont framework is designed to surface, and it's exactly what the exam tests here.

Why the others fail

B — Company A's ROE will be strictly lower than Company B.

Higher leverage mechanically increases the Equity Multiplier term in the DuPont identity, which raises ROE (holding margin and turnover constant) — Company A's ROE will be higher, not lower.

C — Company A's ROE will be completely unaffected by its financial leverage.

The Equity Multiplier is one of the three direct multiplicative components of the DuPont ROE formula; a change in leverage directly and mechanically changes ROE, it cannot leave ROE unaffected.

D — Company A will be legally prohibited from distributing dividends to shareholders.

Higher financial leverage does not create any legal prohibition on paying dividends; dividend policy is a separate board decision governed by profitability, cash position, and Companies Act rules.