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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

BEP, ROE, AND ROIC Duval Manufacturing recently reported the following information:

Net income $ 600,000
ROA 8%
Interest expense $ 225,000
Accounts payable and accruals $1,000,000

Duval’s tax rate is 35%. Duval finances with only debt and common equity, so it has no preferred stock. 40% of its total invested capital is debt, while 60% of its total invested capital is common equity. Calculate its basic earning power (BEP), its return on equity (ROE), and its return on invested capital (ROIC).

Summary Introduction

To determine: Basic earning power (BEP), return on equity (ROE) and return on invested capital (ROIC).

Basic Earning Power (BEP): It represents the raw earning capacity of the firm that is before interest and tax. It can be calculated by dividing earnings before interest and tax to total assets.

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 share holders to 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 earnings available for investors to total invested capital.

Explanation

Solution:

Given,

Net income is $600,000.

Return on assets (ROA) is 8%.

Interest expenses are $225,000.

Accounts payable and accruals are $1,000,000.

Tax rate is 35%.

40% of total capital is debt.

60% of total capital is equity.

Calculated values,

Earnings before interest and tax are $1,148,076.92.

Total assets $7,500,000.

Common equity is $3,900,000.

Debt is $2,600,000.

Formula to calculate basic earning power,

BasicEarningPower=Earning BeforeInterestandTaxTotalAssets

Substitute $1,148,076.92 for earnings before interest and tax and $7,500,000 for total assets.

BasicEarningPower=$1,148,076.92$7,500,000=0.15or15%

Here, basic earning power (BEP) is 15%.

Formula to calculate return on equity,

Return on Equity=NetIncomeCommonEquity

Substitute $600,000 for net income and $3,900,000 for common equity.

Return on Equity=$600,000$3,900,000=0.15or15%

Here, return on equity is 15%.

Formula to calculate return on invested capital,

Return on Invested Capital=Earning BeforeInterestandTax×(1Tax)Debt+CommonEquity

Substitute $1,148,076.92 for earnings before interest and tax, 0.35 for tax, $2,600,000 for debt and $3,900,000 for common equity.

Return on Invested Capital=$1,148,076.92×(10.35)$2,600,000+$3,900,000=$1,148,076.92×0.65$6,500,000=$746249.99$6,500,000=0.1148or11.48%

Here, return on invested capital is 11.48%.

Working note:

Given,

Net income is $600,000.

Return on assets (ROA) is 8%.

Interest expenses are $225,000.

Accounts payable and accruals are $1,000,000.

Tax rate is 35%.

40% of total capital is debt.

60% of total capital is equity

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