Muscarella Inc. has the following balance sheet and income statement data: Cash
ID: 2739043 • Letter: M
Question
Muscarella Inc. has the following balance sheet and income statement data:
Cash
$ 14,000
Accounts payable
$ 42,000
Receivables
70,000
Other current liabilities
28,000
Inventories
210,000
Total CL
$ 70,000
Total CA
$294,000
Long-term debt
70,000
Net fixed assets
126,000
Common equity
280,000
Total assets
$420,000
Total liab. and equity
$420,000
Sales
$280,000
Net income
$ 21,000
The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.70, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change?
a.
4.28%
b.
4.50%
c.
4.73%
d.
4.96%
e.
5.21%
Cash
$ 14,000
Accounts payable
$ 42,000
Receivables
70,000
Other current liabilities
28,000
Inventories
210,000
Total CL
$ 70,000
Total CA
$294,000
Long-term debt
70,000
Net fixed assets
126,000
Common equity
280,000
Total assets
$420,000
Total liab. and equity
$420,000
Sales
$280,000
Net income
$ 21,000
Explanation / Answer
Compute the amount of inventory to be sold to get a current ratio of 2.70.
2.7 = (Total current assets - Inventory sold) / Total current liabilities
= (294,000 - Inventory sold) / 70,000
Or,
2.7 x 70,000 = 294000 - Inventory sold
Or,
Inventory sold = 294,000 - (2.7 x 70,000) = 105,000
Thus, inventory for $105,000 were sold and the cash was used to buy back common stock at book value.
When $105,000 common stock are purchased the new balance of common equity will be $175,000 ($280,000 - $105,000).
ROE before buy back of common stock = Net income / common equity
= $21,000 / $280,000
= 7.5%
ROE after buy back of common stock = $21,000 / $175,000 = 12%
Therefore, the ROE will change by 12% - 7.5% = 4.5%
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