Question

1. The firm, MBI, has Total Assets of $190,000, Equity of $100,000, Net Profit Margin of 3.7 percent, Total Asset Turnover of 2.89. Calculate the firm’s Return on Equity, ROE (Hint: Use DuPont Identity). If the firm increases its debt-equity ratio will the ROE increase or decrease?

20.32 percent, increase

20.32 percent, decrease

38.99 percent, increase

38.99 percent, decrease

5.67 percent, increase

2. A firm has Net Income of $60,800 and has Total Assets of $601,991. The firm’s payout ratio is 25 percent. What is the firm’s Internal Growth rate? Can the firm grow at 6 percent without
raising external funds and why? (Hint: Need to compute ROA).

2.53 percent; No, because 6 percent < Internal Growth Rate

2.53 percent; Yes, because 6 percent < Internal Growth Rate

8.20 percent; Yes, because 6 percent < Internal Growth Rate

8.20 percent; No, because 6 percent < Internal Growth Rate

3. A firm has Net Income of $60,800 and has Total Assets of $601,991, and Total Equity of $400,000. The firm’s payout ratio is 25 percent. What is the firm’s Sustainable Growth Rate? If the firm grows at this rate will its debt-to-equity ratio increase, decrease, or remain the same? (Hint:
Need to compute ROE).

3.95 percent; Increase

3.95 percent; Decrease

12.87 percent; Decrease

12.87 percent; Increase

12.87 percent; Constant

Answer 1

Answer to Question 1 is A:

Equity Multiplier = Total Assets / Equity
Equity Multiplier = $190,000 / $100,000
Equity Multiplier = 1.90

Return on Equity = Net Profit Margin * Total Asset Turnover * Equity Multiplier
Return on Equity = 3.70% * 2.89 * 1.90
Return on Equity = 20.32%

If debt-equity ratio increases, then equity multiplier will also increase which will lead to increase in ROE.

Answer to Question 2 is D:

Return on Assets, ROA = Net Income / Total Assets
Return on Assets, ROA = $60,800 / $601,991
Return on Assets, ROA = 0.1010 or 10.10%

Retention Ratio, b = 1 - Payout Ratio
Retention Ratio, b = 1 - 0.25
Retention Ratio, b = 0.75

Internal Growth Rate = [ROA * b] / [1 - ROA * b]
Internal Growth Rate = [0.1010 * 0.75] / [1 - 0.1010 * 0.75]
Internal Growth Rate = 0.07575 / 0.92425
Internal Growth Rate = 0.0820 or 8.20%

Yes, the firm can grow at a rate of 6% without raising external funds as Internal Growth Rate is higher than 6%.

Answer to Question 3 is D:

Return on Equity, ROE = Net Income / Total Equity
Return on Equity, ROE = $60,800 / $400,000
Return on Equity, ROE = 0.152 or 15.20%

Retention Ratio, b = 1 - Payout Ratio
Retention Ratio, b = 1 - 0.25
Retention Ratio, b = 0.75

Sustainable Growth Rate = [ROE * b] / [1 - ROE * b]
Sustainable Growth Rate = [0.1520 * 0.75] / [1 - 0.1520 * 0.75]
Sustainable Growth Rate = 0.1140 / 0.8860
Sustainable Growth Rate = 0.1287 or 12.87%

If debt-equity ratio increases, then equity multiplier will also increase which will lead to increase in ROE. Increase in ROE will increase the Sustainable Growth Rate.