Question

4.7

Baker Industries’ net income is $24,000, its interest expense is $6,000, and its tax rate is 25%. Its notes payable equals $23,000, long-term debt equals $70,000, and common equity equals $245,000. The firm finances with only debt and common equity, so it has no preferred stock. What are the firm’s ROE and ROIC? Do not round intermediate calculations. Round your answers to two decimal places.

ROE:   %

ROIC:   %

Answer 1

Solution:

Calculation of ROE ( Return on Equity ):

The formula for calculating the ROE is

= Net Income / Common Equity

As per the information given in the question we have

Net Income = $ 24,000 ; Common Equity = $ 245,000

Applying the above information in the formula we have

= $ 24,000 / $ 245,000

= 0.097959

= 9.7959 %

= 9.80 % ( when rounded off to two decimal places )

Thus the ROE = 9.80 %

Calculation of ROE ( Return on Invested Capital ):

The formula for calculating the ROIC is

= EBIT * ( 1 – T) / Total Invested Capital

As per the Information given in the question we have

Net Income = $ 24,000 ; Interest Expense = $ 6,000   ; Tax rate = t = 25 % = 0.25

We know that EBIT = [ Net Income / ( 1 – Tax rate ) ] + Interest Expense

Applying the available information we have

= [ $ 24,000 / ( 1 – 0.25 ) ] + $ 6,000

= ( $ 24,000 / 0.75 ) + $ 6,000

= $ 32,000 + $ 6,000

= $ 38,000

Thus EBIT = $ 38,000

To calculate EBIT * ( 1 – T )

= $ 38,000 * ( 1 – 0.25 )

= $ 38,000 * 0.75

= $ 28,500

Thus EBIT* ( 1- T) = $ 28,500

To calculate Total of Invested capital

As per the information given in the question we have

Notes payable = $23,000   ;   long-term debt = $70,000    ;     common equity = $245,000

Thus Total Invested capital = Notes payable + long-term debt + common equity

= $23,000 + $70,000 + $245,000

= $ 338,000

Thus we have EBIT * ( 1 – T ) = $ 28,500   ; Total Invested Capital = $ 338,000

Thus ROIC = $ 28,500 / $ 338,000

= 0.084320

= 8.4320 %

=8.43 % ( when rounded off to two decimal places )

Thus the ROIC = 8.43 %