Quigley Inc. is considering two financial plans for the coming year. Management

Question

Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000 operating costs to be $265,000 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 3.2 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. 7.25%

B.7.40%

C. 8.73%

D.7.10%

E.8.21%

Explanation / Answer

Plan A Plan B Interest Rate 8.80% 8.80% Tax Rate 35% 35% Assets $200,000 $200,000 Debt Ratio:Plan A Given, Plan B Calculated 25% 49.70% Debt $50,000 $99,432 Equity $150,000 $100,568 Sales $300,000 $300,000 Operating Cost $265,000 $265,000 EBIT $35,000 $35,000 Interest $4,400.0 $8,750.0 Taxable Income $30,600.0 $26,250.0 Taxes $10,710.0 $9,187.5 Net Income $19,890.0 $17,062.5 ROE=NI/Equity 13.26 16.97 TIE=EBIT/Interest 7.95 4.00 Minimum TIE 3.2 3.2 $ of interest consistant with minimum TIE=EBIT/Min TIE= $10,937.50 $10,937.50 Max Debt=Interest/Interest Rate= $50,000.00 $99,432.00 Change in ROE 3.71

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