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Homework answers / question archive / Last year "ABC" Coprpartion had the folliang financial information 1
Last year "ABC" Coprpartion had the folliang financial information 1. Total sales revenue with an amount of $500,000, 2. Total operating costs with an amount of $450,000, and 3. The year-end assets amounted to $395,000. 4. The debt ratio was equal to 17%, the interest rate on the debt was 7.5%, and S. The firm's tax rate was 35%. The current CFO wants to see how the ROE would have been affected if the firm had used a 50% debt ratio. Assume that sales, operating costs, total assets, and the tax rate would not be affected, but the interest rate would rise to 8.0% 1. What is the current (old) ROE? 2. What is the new ROE? 3. By how much would the ROE change in response to the change in the capital structure?
Answer:
ROE (return on equity) = Net profit / Equity capital
So first we need to find net profit,
Net profit = (Operating profit - interest cost) * (1 - Tax rate)
Operating profit = Sales - operating cost
= $ 500,000 - $ 450,000
= $ 50.000
To find interest cost we need to know debt capital,
Debt capital is 17% of total asset
= 17% * $ 395,000
= $ 67,150
So interest cost at 7.5% is,
= 7.5% * $ 67,150
= $ 5036.25
Now net profit is,
Net profit = (Operating profit - interest cost) * (1 - Tax rate)
= ( $ 50,000 - $ 5036.25 ) * (1 - 35%)
= $ 29,226.44
Now return on equity is,
ROE (return on equity) = Net profit / Equity capital
= $ 18,226.44 / $ 327,850
= 5.57%
Now debt is 50% then ROE is,
ROE = new net profit / New capital
Operating profit will remain same
New debt is,
= 50% * $ 395,000
= $ 197,500
So interest cost at 8% is,
= 8% * $ 197,500
= $ 15,800
Net profit = (Operating profit - interest cost) * (1 - Tax rate)
= $ 50,000 - $ 15,800) * (1 - 35%)
= $ 22,230
ROE = new net profit / New capital
= $ 22,230 / $ 197,500
= 11.26%
So change in ROE by change in capital structure is,
= ( 11.26 / 5.57 ) - 1
= 102.15%
So 102.15% is change in ROE due change in capital structure.
