What does an increase in leverage indicate for a firm's ROE according to the DuPont Framework?

An increase in leverage generally indicates that a firm is using more debt relative to equity to finance its operations. According to the DuPont Framework, return on equity (ROE) is calculated by multiplying three components: profit margin (net income/sales), asset turnover (sales/assets), and financial leverage (assets/equity).

When leverage increases, assuming that the firm can maintain or improve its profit margins and asset turnover, the overall effect on ROE is an increase. This occurs because using more debt can amplify the returns on equity when the company is able to generate sufficient returns that exceed the cost of that debt. Thus, increased leverage can result in higher net income without a proportional increase in equity, leading to a higher ROE.

However, it is important to note that increased leverage also introduces more risk. If a firm’s returns do not exceed its financing costs, the effects could be detrimental, but in general terms and under the assumption that the firm is performing well, increased leverage will typically lead to an increase in ROE as stated in the correct answer.