Multi-Part 16-1:Zorn Corporation is deciding whether to pursue a restricted or r
ID: 2749729 • Letter: M
Question
Multi-Part 16-1:Zorn Corporation is deciding whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2. Refer to Multi-Part 16-1. What's the difference in the projected ROEs under the restricted and relaxed policies?
please show me how.
Explanation / Answer
Expected Annual Sales = $ 3,600,000
Fixed Asset Turnover = 4.0
Fixed Asset turnover Ratio = Sales / Net Fixed Assets = $ 3,600,000/Fixed Assets = 4
Fixed Assets = $ 3,600,000/4 = $ 900,000
Given Debt = Equity = 0.5 * Total Assets
Debt = Total Assets / 2
Interest rate on debt = 10%
Interest on debt = (Total Assetes / 2) *0.10 = 0.05 * Total Assets
Under Restricted Policy
Total Asset Turnover = 2.5
Sales / Total Assets = 2.5 ==> $ 3,600,000/Total Assets = 2.5
Total Assets = $ 3,600,000 / 2.5 = $ 1,440,000
Debt = Total Assets / 2 = $ 1,440,000/2 = $ 720,000
Equity = $ 720,000
Current Assets = Total Assets – Fixed Assets = $ 1,440,000 - $ 900,000 = $ 540,000
Debt Interest = $ 720,000 * 0.10 = $ 72,000
EBIT = $150,000
EBT = EBIT – Interest = $ 150,000 - $ 72,000 = $ 78,000
EAT = EBT – Tax = $ 78000 - $ 78000 * 0.40 = $ 78,000 - $ 31,200 = $46,800
ROE under restricted current asset investment policy = EAT/Total Equity * 100
= ($ 46800/$720000) * 100
= 0.065 or 6.50%
Under relaxed policy
Total Asset Turnover = 2.2
Sales / Total Assets = 2.2 ==> $ 3,600,000/Total Assets = 2.2
Total Assets = $ 3,600,000 / 2.2 = $ 1,636.363.63 or $ 1,636,364 (rounded off)
Debt = Total Assets / 2 = $ 1,636,364/2 = $ 818,182
Equity = $ 818,182
Current Assets = Total Assets – Fixed Assets = $ 1,636,364 - $ 900,000 = $ 736,364
Debt Interest = $ 818182 * 0.10 = $ 81818.20
EBIT = $150,000
EBT = EBIT – Interest = $ 150,000 - $ 81,818.20 = $ 68,181.80
EAT = EBT – Tax = $ 68,181.80 - $ 68181.80 * 0.40 = $ 68181.80 - $ 27272.72 = $ 40909.08
ROE under restricted current asset investment policy = EAT/Total Equity * 100
= ($ 40909.08/$818182) * 100
= 0.0499999 or 5.00% (rounded off)
Difference in ROE = ROE under restricted policy – ROE under relaxed policy
= 6.50% - 5.00% = 1.50%
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