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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

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

Net income $615,000
ROA 10%
Interest expense $202,950
Accounts payable and accruals $950,000

Broward’s tax rate is 30%. Broward finances with only debt and common equity, so it has no preferred stock. 40% of its total invested capital is debt, and 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).

Introduction:

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 the equity shareholders. It can be calculated by dividing the earnings available for equity shareholders 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

Given,

Net income is $615,000.

Return on assets (ROA) is 10%.

Interest expenses are $202,950.

Accounts payable and accruals are $950,000.

Tax rate is 30%.

40% of total capital is debt.

60% of total capital is equity.

Calculated values (working note),

Earnings before interest and tax are $1,081,521.43.

Total assets $6,150,000.

Common equity is $3,120,000.

Debt is $2,080,000.

Basic earning power

Formula to calculate basic earning power,

Basicearningpower=Earning beforeinterestandtaxTotalassets

Substitute $1,081,521.43 for earnings before interest and tax and $6,150,000 for total assets.

Basicearningpower=$1,081,521.43$6,150,000=0.1759or17.59%

Here, basic earning power (BEP) is 17.59%.

Return on equity

Formula to calculate return on equity,

Return on equity=NetincomeCommonequity

Substitute $615,000 for net income and $3,120,000 for common equity.

Return on equity=$615,000$3,120,000=0.1971or19.71%

Here, return on equity is 19.71%.

Return on invested capital

Formula to calculate return on invested capital,

Return on invested capital=Earning beforeinterestandtax×(1Tax)Debt+Commonequity

Substitute $1,081,521.43 for earnings before interest and tax, 0.30 for tax, $2,080,000 for debt and $3,120,000 for common equity.

Return on invested capital=$1,081,521.43×(10.30)$2,080,000+$3,120,000=$1,081,521.43×0.70$5,200,000=$757,065$5,200,000=0.1456or14.56%

Here, return on invested capital is 14.56%.

Working note:

Calculation of earnings before tax but after interest,

Earnings before tax but after interest=Netincome1Tax=$615,00010

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