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Question: 1. What are some potential problems and limitations of financial ratio analysis? 2. Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity. 3. Discuss the tradeoff between dividends and growth; elaborate on the use and limitations of the DividendDiscount model. The answer: 1. What are some potential problems and limitations of financial ratio analysis? Financial ration analysis in the calculation and comparison of ratios which are derived from the information in a company’s financial statements. Financial ratio analysis is limited in that it only has the information on the financial statements. Sometimes financial statements are intentionally inaccurate. The analysis is based on past performance, it is hampered when accounting policies are not the same across an industry. 2. Explain how the Du Pont system of analysis breaks down return over assets. Also explain how it breaks down return on stockholder’s equity. The Du Pont system breaks down the return over assets (ROA) by analyzing the separate factors that influence performance, called decomposition. Profit margin=Net Income/Sales Asset Turnover = Sales/Total Assets Return on Assets=Profit Margin x Asset turnover Return on Equity= Return on Assets/(1-debt/Assets) 3. Discuss the tradeoff between dividends and growth; elaborate on the use and limitations of the Dividend-Discount model. When a company chooses to pay dividends this means they have less money for investment versus just being able to reinvest the dividend. The use of the DDM method is the find the value of a stock. Under this formula, the value of a stock is equal to the present value of all future dividends it pays. One of the limitations of the DDM Model is that one would need to know the future dividends. Furthermore, it is changed by growth rate and the discount rate. ...
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