Explanation

Return on Equity (ROE) can be decomposed using the DuPont formula:

ROE = Net Profit Margin × Asset Turnover × Financial Leverage

Where:

• Net Profit Margin = Net Income / Revenue
• Asset Turnover = Revenue / Average Total Assets
• Financial Leverage = Average Total Assets / Average Shareholders' Equity

Alternatively, ROE can also be expressed as:

ROE = (Net Income / Sales) × (Sales / Assets) × (Assets / Equity)

From this decomposition:

1. Leverage (Assets/Equity) directly multiplies with the other components to determine ROE
2. Tax rate affects net profit margin (lower tax rate increases net income, thus increasing ROE)
3. Days of sales outstanding affects asset turnover (lower DSO improves asset turnover, thus increasing ROE)

Analysis of each option:

A. Leverage - A decrease in leverage (Assets/Equity ratio) would directly reduce ROE, all else being equal. This is because leverage amplifies the return on equity when the return on assets is positive.

B. The tax rate - A decrease in the tax rate would increase net income, which would increase ROE, not decrease it.

C. Days of sales outstanding - A decrease in DSO would improve asset turnover (more efficient use of assets), which would increase ROE, not decrease it.

Therefore, only a decrease in leverage would result in a lower ROE, making option A the correct answer.

Key Takeaway: In the DuPont analysis, financial leverage is a multiplier that amplifies ROE when return on assets is positive. Reducing leverage reduces this amplification effect, leading to lower ROE.