Exhibit 15.1 Zorn Corporation is deciding whether to pursue a restricted or rela

Question

Exhibit 15.1 Zorn Corporation is deciding whether to pursue a restricted or relaxed working capital investment policy. The firm's annual sales are expected to total $4,400,000, 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 Exhibit 15.1. Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same. In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies?

a. 1.88% b. 2.12% c. 2.21% d. 1.55% e. 1.83%

Explanation / Answer

ROE ( Relaxed policy)

Sales = 4400,000

Assets = 4400,000 / 2.2 = 2000,000

Debt = 1000,000 and equity = 1000,000 since 50% each in total assets (given)

EBIT = 150000 and EBT = 150000 - 10% of Debt = 50,000

ROE = 50000 * 0.60 / 1000,000 * 100 = 3 %

Restricted

Assets = 4400,000 * 0.85 / 2.5 = 1496,000

Debt = 748,000 and equity = 748,000 since 50% each in total assets (given)

EBIT = 135000 ie ....... 150000 - 10% decrease and EBT = 135000 - 10% * 748000 = 60200

ROE = 60200 * 0.60 / 748,000 * 100 = 4.83%

So difference = 4.83 - 3 = 1.83 % .................final answer = Option - e

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