Question

Last year Hamdi Corp. had sales of $500,000, operating costs of $450,000, and year-end assets (which is equal to its total invested capital) of $385,000. The debt-to-total-capital ratio was 17%, the interest rate on the debt was 7.5%, and the firm's tax rate was 35%. The new CFO wants to see how the ROE would have been affected if the firm had used a 50% debt-to-total-capital ratio. Assume that sales, operating costs, total assets, total invested capital, and the tax rate would not be affected, but the interest rate would rise to 8.0%. By how much would the ROE change in response to the change in the capital structure? Do not round your intermediate calculations.

Answer 1

OLD

Interest Rate - 7.5%

Tax Rate - 35%

Assets - $3,85,000

Debt Ratio = 17%

Debt = Asset * Debt ratio = 3,85,000*17% = $65,450

Equity = Assets - Debt = $3,85,000 - $ 65,450 = $3,19,550

Sales = $5,00,000

Operating Cost = $4,50,000

EBIT = $5,00,000 - $ 4,50,000 = $ 50,000

Interest Paid = Debt * Interest Rate = $65,450 * 7.5% = $4,909

Taxable Income = $ 45,091

Taxes = $15,782

Net Income = $29,309

ROE = Net Income/Equity =$29309/$3,19,550 = 9.17%

NEW

Interest Rate - 8%

Tax Rate - 35%

Assets - $3,85,000

Debt Ratio = 50%

Debt = Asset * Debt ratio = 3,85,000*50% = $1,92,500

Equity = Assets - Debt = $3,85,000 - $ 1,92,500 = $1,92,500

Sales = $5,00,000

Operating Cost = $4,50,000

EBIT = $5,00,000 - $ 4,50,000 = $ 50,000

Interest Paid = Debt * Interest Rate = $1,92,500 * 8% = $15,400

Taxable Income = $ 34,600

Taxes = $12,110

Net Income = $22,490

ROE = Net Income/Equity =$22,490/$1,92,500 = 11.68%

Change in ROE = 11.68 - 9.17 = 2.51%