Question

Pacific Packaging's ROE last year was only 6%; 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 $688,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,856,000 on sales of $16,000,000, and it expects to have a total assets turnover ratio of 2.5. Under these conditions, the tax rate will be 35%. If the changes are made, what will be the company's return on equity? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

EBIT = $1,856,000

annual interest charges = $688,000

EBT = EBIT - Interest = $1,856,000 - $688,000 = $1,168,000

EAT = EBT - Tax = $1,168,000 *(1-0.35) = $759,200

Asset turnover ratio = total sales/ total assets

2.5=$16,000,000/total assets

total assets = $6,400,000

If debt is 40% of capital then equity capital is 60% of total capital.

debt+equity = total assets, so 0.6 of total asset must be equal to equity capital.

Equity capital = $6,400,000 * 0.6

Equity capital= $3,840,000

Formula for ROE=Net income/Equity capital

ROE = $759,200 / $3,840,000

ROE = 19.77%