Question

4-3! PIONILADILY RALIUS Problem Walk-Through Return on Equity Midwest Packaging's ROE last year was only 5%; but its management has developed a new operating plan that calls for a debt-to-assets ratio of 60%, which will result in annual interest charges of $510,000. The firm has no plans to use preferred stock. Management projects an EBIT of $1,695,000 on sales of $15,000,000, and it expects to have a total assets turnover ratio of 2.8. Under these conditions, the tax rate will be 35%. If the changes are made, what will be the company's return on equity? Round your answer to two decimal places.

Answer 1

New operations will have a Debt-to-assets ratio = 60%

As, Total Assets = Debt+Shareholder's Equity

Equity-to-Assets ratio = 100% - 60% = 40% (Taking Total assets as 100% and Debt being 60% of Assets which makes Equity as 40% of it)

Equity Multiplier = Total Asset/Shareholder's equity or 1/Shareholder's Equity-to- Asset ratio

= 1/40%

= 2.5 times

Calculating Net profit of new Operations:

Particular	Amount($)
EBIT	1,695,000
Less: Interest Expenses	(510,000)
EBT	1185,000
Less: Tax @ 35%	(414,750)
Net Profit/Income	770,250

Net Profit Margin = Net Profit/Sales

= $770250/15000,000

= 5.135%

As per DuPont Identity,

ROE = Net Profit margin*Total Assets Turnover*Equity multiplier

= 5.135%*2.8*2.5

= 35.95%

Hence, ROE if changes are made will be 35.95%