   Chapter 4, Problem 7P Fundamentals of Financial Manageme...

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

Solutions

Chapter
Section Fundamentals of Financial Manageme...

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

ROE AND ROIC Baker Industries’s net income is $24,000, its interest expense is$5,000, and its tax rate is 40%. Its notes payable equals $27,000, long-term debt equals$75,000, and common equity equals $250,000. The firm finances with only debt and common equity, so it has no preferred stock. What are the firm’s ROE and ROIC? Summary Introduction To determine: Return on equity (ROE) and return on invested capital (ROIC). Introduction: Return on Equity: Return on equity represents the amount of return earned by equity shareholders. It can be calculated by dividing earnings available for the equity shareholders to the total equity capital. 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, Net income is$24,000.

Long term debt is $75,000. Common equity is$250,000.

Tax rate is 40%.

Formula to calculate return on equity,

Return on equity=NetincomeCommonequity

Substitute $24,000 for net income and$250,000 for common equity in the above formula,

Return on equity=$24,000$250,000=9.6%

Here, return on equity is 9.6%.

Formula to calculate return on invested capital,

Return on invested capital=Earning beforeinterestandtax×(1Tax)Notes Payable+Long-term debt+Commonequity

Substitute $45,000 for earnings before interest and tax, 0.4 for tax,$27,000 for notes payable, $75,000 for debt and$250,000 for common equity in the above formula,

Return on invested capital=$45,000×(10.4)$27,000+$75,000+$250,000=\$45,000×0

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