Question

6. Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets of $195,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and the firm's tax rate was 37%. The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. By how much would the ROE change in response to the change in the capital structure?

7. Last year Altman Corp. had $205,000 of assets, $303,500 of sales, S18,250 of net income, and a debt-to-total-assets ratio of 41%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets to $152,500. Sales, costs, and net income would not be affected, and the firm would maintain the 41% debt ratio. By how much would the reduction in assets improve the ROE?

Answer 1

Total assets:			195000
Debt to total assets			27%
Debts = 195000*27%			52650
Equity (Total assets -Debts)			142350
Current ROE:
Sales			303225
Less: Operating cost			267500
Operating income			35725
Less: Interest (52650*8.2%)			4317.3
Net income before tax			31407.7
Less: Tax @ 37%			11620.85
After tax income			19786.85
Divide: Equity			142350
ROE			13.90%
Proposed:
Total assets			195000
Debt to Total assets			45%
Debts = 195000*45%			87750
Equity (Total assets -Debts)			107250
Proposed ROE:
Sales			303225
Less: Operating cost			267500
Operating income			35725
Less: Interest (87750*8.2%)			7195.5
Net income before tax			28529.5
Less: Tax @ 37%			10555.92
After tax income			17973.59
Divide: Equity			107250
ROE			16.76%
ROE has been increased by 2.86% with the change in capital structure.