Last year, Marly Brown, Inc., reported an ROE of 20 percent. The firm debt-to-eq

Question

Last year, Marly Brown, Inc., reported an ROE of 20 percent. The firm debt-to-equity was 1.50 times, sales were $20 million, the capital intensity was 1.25 times, and dividends paid to common stock holders were $1,000,000. The firms has no preferred stock outstanding. This year, Marly Brown plans to decrease its debt-to-equity ratio to 1.20 times. The change will not affect sales, total assets, or dividends paid, however it will reduce the firms profit margin to 9.85 percent. Use the Dupont equation to determine how the change in Marly Brown’s debt ratio will affect its internal growth rate

Explanation / Answer

Capital intensity ratio = Total asset /sales

           1.25 = TA / 20

Total asset = 20*1.25

                  = 25 million

Let equity Be X so Debt = 1.2x

X +1.2X = 25,000,000

2.2X= 25,000,000

X = 11363636.36

Total asset /equity = 25000000/ 11363636.36

                          = 2.20

ROE = Profit margin *Asset turnover * Financial leverage

         = 9.85 * 1/1.25 * 2.2

        = 17.336 %

Profit = 20000000*.0985 = 1970000

Retention ratio = (1970000-1000000) /1970000 = 970000/1970000 = .4924

Growth = .4924* 17.336 = 8.54%

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