
Originally Posted by
Sitri
Return on equity Midwest Packaging’s ROE last year was only 3 percent, but its management
has developed a new operating plan that calls for a total debt ratio of 60 percent,
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 percent. If the changes are
made, what will be its return on equity?
Well, if this had been two beers earlier, it would be easier.
But from memory,
You need to get the return which will now be 1,000,000 less interest of 300000=$700,000 before taxes.
equity was 100% and now it will be 40% since 60% is now debt. We have to figure out the total old equity. Since it was 3% after tax, lets take it to before tax 3%(1-34% tax rate)=4%. So $1,000,000 profit was equal to 4%. So total equity was $25,000,000 before financing (i).
Now, I guess this is one of those academic problems where we keep the same capitalization and somehow dividend 60% of our stock capitalization back to shareholders so poof, our capitalization becomes $10 mill in stock and $15 in debt. Being CEO, I get $1,000,000 for figuring this shit out.
So, our ROE is now (1,000,000-300,000)/ 10,000,000)*.66 or 7%*.66 or 4.8% illustrating why you should leverage your ass off.
Of course, this can be totally wrong.
I have no idea what asset turnover has to do with this...
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