Question

Last year Ann Arbor Corp had $195,000 of assets (which equals total invested capital), $305,000 of sales, $20,000 of net income, and a debt-to-total-capital ratio of 37.5%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $33,000. The firm finances using only debt and common equity. Assets, total invested capital, sales, and the debt to capital ratio would not be affected. By how much would the cost reduction improve the ROE? Do not round your intermediate calculations.

Answer 1

The cost reduction would improve the ROE by 10.67%

Step-by-step explanation:

Debt is 37.5% of Total capital or we can say equity is 62.5% of total capital.

Total capital = $195,000

Equity = $195000*62.5%

= $121,875

Old ROE = (Net income/Total Equity)*100

= ($20,000/$121875)*100

= 16.41025641%

New ROE = ($33000/$121875)*100

= 27.076923076%

Improvement in ROE = 27.076923076% - 16.41025641%

= 10.6666666666%

Therefore, The cost reduction would improve the ROE by 10.67%