SUM Inc. has debt-to-equity ratio of 75%, profit margin of 10%, total sales of 1
ID: 2768076 • Letter: S
Question
SUM Inc. has debt-to-equity ratio of 75%, profit margin of 10%, total sales of 15 million and total assets of 5 million. The president is unhappy with the current return on equity, and he thinks it could be doubled. This could be accomplished by (1) increasing the profit margin to 14% and (2) increasing debt utilization. Total asset turnover will not change. What new debt-to-equity ratio is required to double the return on equity?
FORMAT TO 4 DECIMAL PLACES
0.65
1.19
2.55
1.50
0.92
SUM Inc. has debt-to-equity ratio of 75%, profit margin of 10%, total sales of 15 million and total assets of 5 million. The president is unhappy with the current return on equity, and he thinks it could be doubled. This could be accomplished by (1) increasing the profit margin to 14% and (2) increasing debt utilization. Total asset turnover will not change. What new debt-to-equity ratio is required to double the return on equity?
FORMAT TO 4 DECIMAL PLACES
A.0.65
B.1.19
C.2.55
D.1.50
E.0.92
Explanation / Answer
Current ROE = (profit margin * total sales )/(total assets * 1/(1+debt-to-equity ratio)
Current ROE = (10%*15) / (5*1/1.75)
Current ROE = 52.50%
increasing the profit margin to 14%
ROE = (14%*15)/(5*1/1.75) = 73.50%
ROE could not be doubled through increasing the profit margin to 14%
Required debt-to-equity ratio = (Required ROE * Total Asset )/ (profit margin * total sales ) -1
Required debt-to-equity ratio = (105% * 5)/(10%*15)-1
Required debt-to-equity ratio = 10.50
ROE could be doubled through increasing debt utilization i.e increasing debt to Equity ratio from 75% to 150%
Increaseing Debt to Equity ratio = 0.75/1.75* 2
New equity multiplier is required = (Required ROE * Total Asset )/ (profit margin * total sales )
New equity multiplier is required = (105% * 5)/(10%*15)
New equity multiplier is required = 3.50
ROE could not be doubled through increasing the profit margin to 14%
ROE could be doubled through increasing debt utilization
New equity multiplier is required = 3.50
Therefore, option D is correct.
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