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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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TIE AND ROIC RATIOS The W.C. Pruett Corp. has $600,000 of interest-bearing debt outstanding, and it pays an annual interest rate of 7%. In addition, it has $600,000 of common stock on its balance sheet. It finances with only debt and common equity, so it has no preferred stock. Its annual sales are $2.7 million, its average tax rate is 35%, and its profit margin is 7%. What are its TIE ratio and its return on invested capital (ROIC)?

Summary Introduction

To determine: Times-interest-earned (TIE) ratio and return on invested capital (ROIC).

Times-Interest-earned (TIE) Ratio:

It represents the firm’s capacity to pay its interest expenses. It is calculated by dividing the earnings before interest and tax to interest expense.

Return on Invested Capital (ROIC):

It represents the amount of return earned by all the investors; it can be calculated by dividing the earnings available for investors to total invested capital.

Explanation

Given,

Debt is $600,000.

Interest on debt is 7%.

Common stock is $600,000.

Sales are $2.7 million.

Average tax rate is 35%.

Profit margin is 7%.

Calculated values,

Earnings before interest and tax are $332,769.23.

Interest expenses are $42,000.

Times-interest-earned ratio

Formula to calculate times-interest-earned (TIE) ratio,

Times-interest-earned (TIE) ratio=EarningbeforeinterestandtaxInterestexpenses

Substitute $332,769.23 for earnings before interest and tax and $42,000 for interest expenses.

Times-interest-earned (TIE) ratio=$332,769.23$42,000=7.92×

Here, time-interest-earned ratio is 7.92× .

Return on invested capital

Formula to calculate return on invested capital,

Return on invested capital=Earning beforeinterestandtax×(1Tax)Debt+Commonequity

Substitute $332,769.23 for earnings before interest and tax, 0.35 for tax, $600,000 for debt and $600,000 for common equity.

Return on Invested Capital=$332,769.23×(10.35)$600,000+$600,000=$332,769

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