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Last year a company had sales of $800,000, operating costs of 70%, and year-end assets of...

Last year a company had sales of $800,000, operating costs of 70%, and year-end assets of $1,500,000. The debt-to-total-assets ratio was 20%, the interest rate on the debt was 10.00%, and the tax rate was 21%. The new CFO wants to see how the ROE would have been affected if the firm had used a 30% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. How much would the ROE change in terms of percentage points in response to the change in the capital structure?

Solutions

Expert Solution

Given facts

Sales = 800000

Total Assets = 1500000

a).ROE When Debt Ratio was 20%

Debt/Total Assets =20%

Debt =Total Assets*20%

=1500000*20%

Debt =300000

Equity =1500000-300000

=1200000

Sales = 800000

(-) Operating Cost (70% of sales) = 560000

Earnings before interest and tax(EBIT) =140000

(-)Interest 300000*10% = 30000

Earnings before tax(EBT) = 110000

(-)Tax @21% = 23100

Earnings after tax(EAT) =86900

Return on Equity (ROE)=EAT/Equity=86900/1200000=0.0724=7.24%

b).ROE When Debt Ratio was 30%

Debt/Total Assets =20%

Debt =Total Assets*30%

=1500000*30%

Debt =450000

Equity =1500000-450000

=1050000

Sales = 800000

(-) Operating Cost (70% of sales) = 560000

Earnings before interest and tax(EBIT) =140000

(-)Interest 450000*10% = 45000

Earnings before tax(EBT) = 95000

(-)Tax @21% = 19950

Earnings after tax(EAT) = 75050

Return on Equity (ROE)=EAT/Equity=75050/1050000=0.0715=7.15%

% of change in ROE due to change in capital structure =.09%(i.e 7.24%-7.15%)

jeff jeffy answered 1 year ago
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