Question

15. A company has $20 billion of sales and $1 billion of net income. Its total assets are $10 billion. The company’s total assets equal total invested capital, and its capital consists of half debt and half common equity. The firm’s interest rate is 5%, and its tax rate is 25%.
    1. What is its profit margin?
    2. What is its ROA?
    3. What is its ROE?
    4. What is its ROIC?
    5. Would this firm’s ROA increase if it used less leverage? (The size of the firm does not change.)

Answer 1

a). Profit Margin = (Net Income/Sales)*100

= ($1 billion/$20 billion)*100

= 5%

b). Return on Assets(ROA) = (Net Income/Total Assets)*100

= ($1 billion/$10 billion)*100

= 10%

- Total Assets = Total Invested Capital

Capital Investment consist of half debt and half equity.

So, Total Equity = Total Invested Capital*50%

= $10 billion*50%

= $5 billion

c). Return on Equity(ROE) = (Net Income/Total Equity)*100

= ($1 billion/$5 billion)*100

= 20%

- Total Debt = Total Invested Capital*50%

= $10 billion*50%

Total Debt = $5 billion

Interest on Debt = $5 billion*5%

= $0.25 billion

EBIT = [Net Income/(1-Tax rate)] + Interest Expenses

= [$1 billion/(1-0.25)] + $0.25 billion

EBIT = $1.5833 billion

d). Return on Invested Capital(ROIC) = EBIT*(1-Tax rate)/Total Invested Capital

= $1.5833 billion/$10 billion

= 15.83%

e). If the firm uses less Leverage which means that less Debt and more Equity in the Current Capital structure (as the size of firm does not change). Less Debt means less Interest rate which will eventually increase the Net income of the firm.

Thus, ROA of the firm will Increase as Net income will rise but Total Assets will remain same.

Hence, ROA will increase.

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