Question

Pacific Packaging's ROE last year was only 4%, but its management has developed a new operating plan that calls for a debt-to-capital ratio of 40%, which will result in annual interest charges of $360,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,164,000 on sales of $12,000,000, and it expects to have a total assets turnover ratio of 3.6. 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

Compute the total assets, using the equation as shown below:

Total assets = Net sales/ Asset turnover ratio

                    = $12,000,000/ 3.60

                    = $3,333,333.33333

Hence, the total assets is $3,333,333.33333.

Compute the debt-capital, using the equation as shown below:

Debt capital = Total assets*Debt-to-capital ratio

                    = $3,333,333.33333*40%

                    = $1,333,333.33333

Hence, the debt-capital is $1,333,333.33333.

Compute the equity capital, using the equation as shown below:

Equity capital = Total assets – Debt capital

                       = $3,333,333.33333 – $1,333,333.33333

                       = $2,000,000

Hence, the equity capital is $2,000,000.

Compute the net income, using the equation as shown below:

Net income = (EBIT – Interest)*(1 – Tax rate)

                   = ($1,164,000 – $360,000)*(1 – 0.25)

                   = $804,000*0.75

                   = $603,000

Hence, the net income of the company is $603,000.

Compute the return on equity (ROE), using the equation as shown below:

ROE = Net income/ Equity capital

         = $603,000/ $2,000,000

         = 30.15%

Hence, the return on equity is 30.15%.