Quigley Inc. is considering two financial plans for the coming year. Management
ID: 2671628 • Letter: Q
Question
Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $301,770, operating costs to be $266,545, assets to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but the TIE ratio would have to be kept at 4.00 or more. Under Plan B the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure?a. 3.83%
b. 4.02%
c. 4.22%
d. 4.43%
e. 4.65%
Explanation / Answer
Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $301,770, operating costs to be $266,545, assets to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but the TIE ratio would have to be kept at 4.00 or more. Under Plan B the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure? ANSWER :a. 3.83% The total assets are financed with 25% debt and 75% equity. Debt = 25% ($200,000)= $50,000 Equity = 75% ($200,000)= $150,000 Interest rate on debt = 8.8% x $50,000= $4,400 Computing the TIE ratio under Plan-A: The formula for calculating the Times Interest Earned ratio is TIE = EBIT / Interest = (Sales - OPerating costs) / Interest = ($301,770 - $266,545) / $4,400 = $35,225 / $4,400 = 8.00 Computing the ROE under Plan-A: ROE = Net income / Total equity EBIT 35225 INTEREST 4400 EBT 30825 TAX RATE 10789 NET INCOME 20036 ROE = $20,036 / $150,000=0.1336 or 13.36% ====================== TIE ratio should be 4.00 and the capital structure should be identified according to the TIE ratio. TIE = EBIT / Interest since we dont know the capital structure in Plan-B, we dont know the interest expense also. 4.00 = $35,225 / Interest Interest = $35,225 / 4.00= $8806 Therefore, the interest expense is $8806 8.8% -------------------- $8806 100%---------------------? Total debt = (100% X $8806 ) / 8.8% = $100,068 Therefore, the total amount of debt = $100,068 Total amount of equity = $200,000 - $100,068= $99,932 ROE = Net income / Total equity But net income will change with change in Interest expense. EBIT 35225 INTEREST 8806 EBT 26419 TAX RATE 9247 NET INCOME 17172 ROE = $17,172 / $99,932= 0.1718 or 17.18% Percentage change in ROE = 17.18% - 13.36%=3.82%
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