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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

RETURN ON EQUITY Midwest Packaging’s ROH last year was only 3%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 60%, which will result in annual interest charges of $300,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,000,000 on sales of $10,000,000, and it expects to have a total assets turnover ratio of 2.0. Under these conditions, the tax rate will be 34%. If the changes are made, what will be the company’s return on equity?

Summary Introduction

To determine: Return on equity (ROE).

Return on Equity: Return on equity represents the amount of return earned by equity share holders; it can be calculated by dividing earnings available for equity shareholders to total equity capital.

Explanation

Solution:

Given,

Total asset turnover ratio is 2.0.

Interest expenses are $300,000.

Earnings before interest and tax are $1,000,000.

Sales are $10,000,000.

Tax rate is 34%.

Debt to capital ratio is 60%.

Calculated values,

Net income is $455,000.

Equity multiplier is 2.5.

Formula to calculate return on equity,

Return on equity=NetincomeSales×Totalassetsturnoverratio×Equitymultiplier

Substitute $455,000 for net income, $10,000,000 for sales, 2 for total assets turnover ratio and 2.5 for equity multiplier.

Return on Equity=$455,000$10,000,000×2×2.50=0.0455×2×2.50=0.2275or22.75%

Here, return on equity is 22.75%

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