Question

Pacific Packaging's ROE last year was only 2%, but its management has developed a new operating plan that calls for a debt-to-capital ratio of 60%, which will result in annual interest charges of $700,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,960,000 on sales of $20,000,000, and it expects to have a total assets turnover ratio of 2.9. Under these conditions, the tax rate will be 25%. If the changes are made, what will be the company's return on equity? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

EBIT = $1,960,000

Interest expense = $700,000

Tax rate = 25%

Net Income = (EBIT – Interest expense) × (1 – Tax Rate)

                    = ($1,960,000 - $700,000) × (1 – 25%)

                    = $1,260,000 × 75%

                    = $945,000

The net income of the company is $945,000.

Profit Margin = Net Income / Total sales

                       = $945,000 / $20,000,000

                       = 4.73 %

Profit Margin of the company is 4.73%.

Assets turnover = 2.90

Debt to capital Ratio = 0.60

Equity Multiplier = 1 / (1 – 60%)

= 2.5

The equity multiplier for the company is 2.5

Now Return on Equity is calculated below using DU Pont Formula:

Return on equity = Equity Multiplier × Assets turnover × Profit margin

                            = 2.5 × 2.9 × 4.73%

  = 34.29 %

The return on equity for the company is 34.29%.