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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?
Expert Solution
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.
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