Question

Pacific Packaging's ROE last year was only 6%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 45%, which will result in annual interest charges of $344,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $704,000 on sales of $8,000,000, and it expects to have a total assets turnover ratio of 3.3. Under these conditions, the tax rate will be 35%. 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

Total Sales = $8,000,000

EBIT = $704,000

Interest = $344,000

PBT = EBIT - Interest = $360,000

Tax = 35%

PAT = PBT*(1-tax rate) = $234,000

Total Asset Turn over ratio = 3.33 = Total Sales/Total Assets

=> Total Assets = Total Sales/3.33

=> Total Assets = 8000000/3.33 = $2,402,402.402

Debt to capital ratio = Total Debt/Total capital

Total Capital = Total debt + Total shareholder's fund = Total assets

=> Total Debt = Debt to capital ratio * Total Assets

=> Total Debt = 45%*2,402,402.402 = $1,081,081.081

Total shareholder's fund = Total Capital - Total Debt = Total Assets - Total Debt = $1,321,321.321

ROE = PAT/Total shareholder's fund = 17.71%