Last year Dustin Corp. had sales of $300,225, operating costs of $265,500, and y
ID: 2662506 • Letter: L
Question
Last year Dustin Corp. had sales of $300,225, operating costs of $265,500, and year-end assets of $190,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.8%, and the firm's tax rate was 37%. The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. By how much would the ROE change in response to the change in the capital structure?Explanation / Answer
present Total Debt = 190000 x 27% = 51300 it means if debt is 51300 then equity is 190000 - 51300 =138700 Interest charges = 51300 x 8.8%= 4514.40 now we will calculate present ROE as follows: $ Sales 300225 operating costs (265500) profit before interest & tax =34725 Interest (4514.40) profit before tax =30210.60 tax @ 37% (11177.92) net return =19032.68 Return on equity = (return / equity) x 100 = (19032.68/ 138700) x 100 = 13.72%Now if we assume 45% debt ratio, means the debt would be190000 x 45% = 85500 equity = 190000-85500 = 104500 (the total assets 190000 aresame as mentioned) new interest charges would be 85500 x 8.8% = 7524. calculation of New ROE profit before interest & tax (same) 34725 interest charges (7524) profit before tax 27201 tax (10064.37) net return 17136.63 ROE = (17136.63/104500) x 100 = 16.40%
Hence change in ROE = 16.40 - 13.72 = 2.68% increase $ Sales 300225 operating costs (265500) profit before interest & tax =34725 Interest (4514.40) profit before tax =30210.60 tax @ 37% (11177.92) net return =19032.68 Return on equity = (return / equity) x 100 = (19032.68/ 138700) x 100 = 13.72%
Now if we assume 45% debt ratio, means the debt would be190000 x 45% = 85500 equity = 190000-85500 = 104500 (the total assets 190000 aresame as mentioned) new interest charges would be 85500 x 8.8% = 7524. calculation of New ROE profit before interest & tax (same) 34725 interest charges (7524) profit before tax 27201 tax (10064.37) net return 17136.63 ROE = (17136.63/104500) x 100 = 16.40%
Hence change in ROE = 16.40 - 13.72 = 2.68% increase
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