Question

Pacific Packaging's ROE last year was only 2%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 45%, which will result in annual interest charges of $175,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $535,000 on sales of $5,000,000, and it expects to have a total assets turnover ratio of 2.1. Under these conditions, the tax rate will be 40%. If the changes are made, what will be the company's return on equity

Answer 1

16.511%

Step-by-step explanation:

According to the scenario, computation of the given data are as follow:-

For computing the return on equity we need to do following calculation

Net Income = (EBIT - Interest Rate) × (1 -Tax Rate)

= ($535,000 - $175,000) × (1 - 40%)

= $360,000 × 60%

= $216,000

Profit Margin = Net Income ÷ Total Sales

= $216,000 ÷ $5,000,000

= 0.0432 or 4.32%

Assets turnover ratio = 2.1

Debt to capital ratio = 45% or 0.45

Equity Multiplier = 1 ÷ (1 - 0.45) = 1.82

As we know that

Return on Equity = Equity Multiplier × Profit Margin × Assets Turnover

= 1.82 × 4.32% × 2.1

= 16.511%

According to the analysis, the company Return on equity is 16.511%