Selected financial data from the June 30 year-end statements of Safford Company

Question

Selected financial data from the June 30 year-end statements of Safford Company are given below: Total assets Long-term debt (11% interest rate) Total stockholders' equity $5,800,000 $610,000 $2,200,000 $67,100 $410,000 Net income Total assets at the beginning of the year were $5,600,000; total stockholders' equity was $2,000,000. The company's tax rate is 35%. Required: 1. Compute the return on total assets. (Round your percentage answer to 1 decimal place (i.e., 0.1234 should be entered as 12.3).) Return on total assets 8.01% 2. Compute the return on equity. (Round your percentage answer to 1 decimal place (i.e., 0.1234 should be entered as 12.3).) Return on equity 19.5% 3. Is financial leverage positive or negative? Positive Negative

Explanation / Answer

1. ROA = (Net Income + Interest Expense net of tax) / Average Total Assets

= ($410,000 + $67,100 x 0.65) / ($5,800,000 + $5,600,000)

= 8.0 %

2. ROE = Net income / avg. Shareholder's equity

= $410,000/ (2,200,000 + 2,000,000)

= 19.5%

3.  The company can use the funds to earn an after-tax rate of 8%. The interest on debt is tax deductible. The tax rate is 35%, the after-tax interest rate would be 7.15% [11% × (1 – 0.35)]. The difference of 0.85% (8% – 7.15%) is, therefore, the benefit of common stockholders. So financial leverage is positive.

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