Question

ABC's return on equity (ROE) was very poor last year, but management has come up with a plan to improve things. The new plan calls for a debt ratio of 58 percent, which will generate interest expenses of $327,000 per year. Management projects that the operating profit margin will be 12.7 percent on sales of $13 million. They project a total asset turnover ratio of 1.9 and a tax rate of 40 percent. Given that information, what will be ABC's ROE under the new plan? (show your answer in decimal form to at least 3 decimal places, so if you calculated net income of 1,000 and equity of 3,000 then you would enter 0.333)

Answer 1

We can use following DuPont equation to calculate ROE under new plan

ROE = Profit margin * Total assets turnover * Equity multiplier

OR

ROE = (Net Income /Sales) * (Sales/Total asset)* (Total assets /Equity) …………………….. (1)

Let’s calculate Net Income based on given information

Sales * Operating profit margin = Operating Income (EBIT)

EBIT = $13 Million * 12.7% = $1.651 million

Income before taxes (EBT) = EBIT - interest expenses = $1.651 million -$327,000

= $1,651,000 - $327,000

= $1,324,000

Now, Net Income = EBT *(1– Taxes)

= $1,324,000 * (1- 40%)

= $ 794,400

Total asset turnover ratio is 1.9 (given)

But we know that, Total assets turnover = Sales/Total asset

Therefore,

Total asset = Sales /Total assets turnover = $13 Million / 1.9 = $6,842,105.263

We know that debt ratio (Debt/Total Asset) =58 %, therefore Equity/Total Asset = 1- 58% = 42%

And Equity multiplier = (Total assets /Equity) = 1/ (Equity/Total Asset) = 1/42% = 2.381

Now putting all the values in equation (1), we get

ROE = ($ 794,400/$13,000,000) * ($13,000,000/ $6,842,105.263)* 2.381

= 0.27644 or 27.644%