Question

Olivia has just graduated from University and was hired by Manutech Inc. to help out with the company's financing decisions. The company has very high profit margins and generates large amounts of free cash flow. It currently has $500,000 in total assets and 10,000 shares outstanding. Because of generous investment tax credits and high rates of depreciation, Manutech does not pay any corporate tax. Manutech currently is all equity financed. The Chief Financial Officer ask Olivia to develop a financial strategy that could increase shareholder value. Olivia spends a week going over the company's financials, Olivia determines that there are three possible profit scenarios. Under the first scenario (recession), operating profits (EBIT) a S10,000 per year. Under the second scenario (expected), operating profits are $25,000 per year. Under the third scenario (expansion), operating profits are $40,000 per year re Olivia proposes the following plan, which will increase average earnings per share and return o equity. More specifically, she proposes that Manutech borrows money from a bank and use the proceeds to repurchase shares. As a result of this transaction, Manutech would have a debt-to- equity ratio of 2. The cost of borrowing from the bank is Please answer the following questions and document each step of your work (points will be deducted for not doing so). You must include a cover page with your submission.

Answer 1

Calculation of Return on Assets (ROA), Return on Equity(ROE) and Earning Per Share(EPS)

We have following information -

Manutech Inc. (firm) is all equity financed

EBIT(recession) = $ 10,000

EBIT(expected) = $ 25,000

EBIT(expansion) = $ 40,000

Corporate tax = 34%

Total Assets = $ 330,000

No. of Shares O/s = 10,000

Equit (E) = Total Assets ..... (in case of all equity finance, otherwise Equity = Assets - Liabilities)

E = $ 330,000

$ROA = \frac{Net Income}{Total Assets}\times 100$

$ROE = \frac{Net Income}{No. of outstanding share}\times 100$

$EPS = \frac{Net Income}{No. of outstanding share}$

(in $)		Recession	Expected	Expansion
	EBIT	10,000	25,000	40,000
less-	TAX	3,400	8500	13,600
	Net Income(I)	6,600	16,500	26,400
	Total Assets(A)	330,000	330,000	330,000
	Equity(E)	330,000	330,000	330,000
	No. of Share(N))	10,000	10,000	10,000
	ROA(I/A*100)	2%	5%	8%
	ROE(I/E*100)	2%	5%	8%
	EPS(I/N)	$ 0.66	$ 1.65	$ 2.64

We can observe that in above case, ROA and ROE is same. This is because, Manutech Inc. is all equity financed.

The basic difference between ROA and ROE is financial leverage if Firm is not financial leveraged then these two ratio would be equal.