   Chapter 4, Problem 14P Fundamentals of Financial Manageme...

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

Solutions

Chapter
Section 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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