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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

RETURN ON EQUITY Pacific Packaging’s ROE last year was only 5%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 40%, which will result in annual interest charges of $561,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,258,000 on sales of $17,000,000, and it expects to have a total assets turnover ratio of 2.1. Under these conditions, the tax rate will be 35%. 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 the equity shareholders. It can be calculated by dividing earnings available for equity shareholders to total equity capital.

Explanation

Given,

Total asset turnover ratio is 2.1.

Interest expenses are $300,000.

Earnings before interest and tax are $1,258,000.

Sales are $17,000,000.

Tax rate is 35%.

Debt to capital ratio is 40%.

Calculated values (working note),

Net income is $453,050.

Equity multiplier is 1.67.

Return on equity

Formula to calculate return on equity,

Return on equity=NetincomeSales×Totalassetsturnoverratio×Equitymultiplier

Substitute $453,050for net income, $17,000,000 for sales, 2.1 for total assets turnover ratio and 1.67 for equity multiplier.

Return on equity=$453,050$17,000,000×2.1×1.67=0.02665×2.1×1.67=0.0935or9.35%

Here, return on equity is 9.35%

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