Question

You are considering adding a new product to your firm's existing product line. It should cause a 10 percent increase in your profit margin (i.e., new PM = old PM x 1.1), but it will also require a 25 percent increase in total assets (i.e., new TA = old TA x 1.25). You expect to finance this asset growth entirely by debt. If the following ratios were computed before the change, approximately what will be the new ROE if the new product is added and sales remain constant? Ratios before new product were Profit margin=0.10, Total assets turnover=2.00, and Equity multiplier=2.00.

• A. 44%
• B. 48%
• C. 25%
• D. 28%
• E. 34%

Answer 1

assume old asset=100

new asset=100*1.25=125

old sales=2*100=200 and new sales=200

old equity=100/2=50, new equity is also=50 as asset growth is done through debt only

new Equity multiplier=125/50=2.50

new asset turnover=200/125=1.60

what will be the new ROE=new profit margin*new asset turnover*new Equity multiplier=(0.10*1.1)*1.60*2.5=0.44

=44%