Question

Last year Kruse Corp had $305,000 of assets, $403,000 of sales, $28,250 of net income, and a debt-to-total-assets ratio of 39%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets to $252,500. Sales, costs, and net income would not be affected, and the firm would maintain the same debt ratio (but with less total debt). By how much would the reduction in assets improve the ROE?

Select one:
a. 3.16%
b. 3.48%
c. 3.00%
d. 3.31%
e. 2.85%

Answer 1

The improvement in the Return on Equity (ROE) after reducing total assets from $305,000 to $252,500 while maintaining a 39% debt ratio is approximately 3.32%. The closest given option is 3.31%.

Step-by-step explanation:

To calculate the improvement in Return on Equity (ROE) resulting from a reduction in total assets, we need to understand that ROE is calculated as Net Income divided by Shareholders' Equity. With a debt-to-total-assets ratio of 39%, the shareholders' equity portion is 61% (100% - 39%). Initially, Kruse Corp had $305,000 of assets and therefore $187,050 of equity (61% of $305,000). After reducing assets to $252,500 with the same debt ratio, the equity would be $153,525 (61% of $252,500). The original ROE is ($28,250 / $187,050) * 100%, which gives us approximately 15.09%. The new ROE would be ($28,250 / $153,525) * 100%, which is roughly 18.41%. The difference between these two percentages will give us the improvement in ROE.

The improvement in ROE is therefore 18.41% - 15.09% = 3.32%. The closest option to our calculated figure is 3.31%, which would be option d.