Question

Pacific Packaging's ROE last year was only 3%; 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 $128,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $364,000 on sales of $4,000,000, and it expects to have a total assets turnover ratio of 2.6. Under these conditions, the tax rate will be 40%. 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

ROE ( previous year ) = 3%

Debt to capital ratio = 60%

Interest charge = $128000

EBIT = $364000

Sales =$ 4000000

Total asset turn over = 2.6

Tax rate = 40%

Retrun on Equity = Net income / Common equity

Calculation of Net income:

Solve from EBIT
EBIT	364000
Less interest	128,000
Income before tax (EBIT - interest)	236000
Less income tax (236000*40%)	94400
Net income	141600

Calculation of Common equity =

Total asset turn over = Sales / Total asset

2.6 = 4,000,000 / Total asset

Total Asset = 4,000,000/ 2.6

= 1538461.53

Common Equity

Now since ;

Total asset = Total invested capital = debt + common equity

then:

Debt to capital ratio = debt / Asset = 60%

Debt /Asset =60%

Debt / 1538461.53 = 60%

Debt = 60% * 1538461.53

= 923076.91

Total asset = Debt + Common equity

1538461.53 =923076.91 + Common equity

Common equity = 1538461.53 - 923076.91

= 615384.62

Return on Equity [ ROE ] ;

ROE =Net income / Common Equity

= 141600 / 615384.62

= 23.00%