Question

7. Last year, Midwest Packaging's ROE was only 3%, but its management has developed a new operating plan that calls for a total debt ratio of 60%, which will result in annual interest charges of $300,000. Management projects an EBIT of $1,000,000 on sales of $10,000,000, and it expects to have a total assets turnover ratio of 2.0. Under these conditions, the tax rate will be 34%. If the changes are made, what will be its return on equity? (231 or 23.1%) BbcA

Answer 1

Asset Turnover Ratio (ATR) = Net Sales / Total Assets     ------>(1)

Given Asset Turnover Ratio =2

=> 2 = 10,000,000/ Total Assets      (from equation 1)

=>Total Assets = 5,000,000         ------>(2)

Now ROE is given by ROE = Net Income / Equity

Net Income = (EBIT - Interest Charges) *(1-tax rate)

Net Income = (1,000,000 -300,000) *(1-34%)

Net Income = $462,000               -------->(3)

Equity = Total Assets *(1-debt ratio)  

Equity = 5,000,000*(1-0.6) = $2,000,000    -------->(4)

From equation 3 and 4

ROE = Net Income / Equity = 462,000/2,000,000 =0.231