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 $225,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $410,000 on sales of $5,000,000, and it expects to have a total assets turnover ratio of 1.9. 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

Given

ROE of previous year = 2%

Debt to capital ratio = 60%

Interest charges = $225,000

Total assets = Total invested capital

EBIT = $410,000

Sales = $5,000,000

Total assets turnover = 1.9

Tax rate = 25%

ROE = Net income/ Common equity

Step 1:

First let us calculate Net income

EBIT                               $410,000

Less: Interest               $225,000

Income before taxes   $185,000

Less Income tax            $46,250

Net income                 $138,750

Step 2:

Calculate total assets

Total assets turnover = Sales/ Total assets

1.9 = $5,000,000/ Total assets

Total assets = $5,000,000/ 1.9 = $2,631,578.95

Step 3:

Calculate debt

Debt to capital ratio = debt/ capital = debt/ assets = 60%

Debt/ $2,631,578.95 = 60%

Debt = 60% * $2,631,578.95 = $1,578,947.37

Step 4:

Calculate common equity

Total assets = debt + common equity

$2,631,578.95 = $1,578,947.37 + common equity

Common equity = $1,052,631.58

Step 5:

Now let us finally calculate ROE = $138,750/ $1052631.58 = 0.1318 = 13.18%

ROE = 13.18%