Pennington Pizzeria\'s ROE last year was only 5 percent, but its management has

Question

Pennington Pizzeria's ROE last year was only 5 percent, but its management has developed a new operating plan designed to improve things. The new plan calls for a total debt ratio of 60 percent, which will result in interest charges of $8,000 per year. Management projects an EBIT of $26,000 on sales of $240,000, and it expects to have a total assets turnover ration of 2.0. Under these conditions, the average tax rate will be 40 percent. If the changes are made, what return on equity will Pennington earn?

Explanation / Answer

26,000 EBIT -8,000 Interest -7,200 taxes ((26,000 – 8,000)*.4) = 10,800 net income Asset Turnover = sales/assets Assets = Sales/Asset Turnover = 240,000/2.0 = 120,000 Debt Ratio = Liabilities/Assets Liabilities = Debt Ratio * Assets = 0.6*120,000 = 72,000 Equity = assets – liabilities = 120,000 – 72,000 = 48,000 Return on Equity = net income/equity = 10,800/48,000 = 0.225 or 22.5%

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