Question

Suppose your goal is to achieve a 10 percent rate of return on equity in your firm this year. Assume the annual cost of debt capital is 8 percent, your firm is in the 20 percent tax bracket and you do not withdraw funds from retained earnings. Further assume your total debt outstanding is $70,000 and your total assets are worth $140,000.

1. What rate of return on assets would your firm have to achieve to hit this target?

2. If you withdrew 10 percent of the firm’s after-tax income, what rate of return on assets would your firm now have to make to achieve the target rate of return on equity?

3. Given your answer to part(b),assume the government passed tax hike that increased your firm’s tax rate to 25 percent. What rate of return on assets would your firm now have to make to achieve this goal?

4. Finally, given your answer to part (c), what would happen to the firm’s rate of return on equity if the rate of return on assets fell to zero? What does this imply about your firm’s exposure to risk?

Answer 1

Return on asset is a prifitability ratio that provides how much profit a company is able to generate from its assets.

ROA=net income/average total assets

Total assets =140000

Tax =20%

Cost of debt capital =8%

Total debt outstanfing =70000

ROA=140000-70000=70000

20% of 70000=14000

8% of 70000=5600

ROA=70000-14000-5600=50400

50400/112000=0.45

45% is rate of return

Rate of return after withdrowing 10% of tax from asset is 56000

56600/112000=0.5

5% is return

Rate of return after government imposing 25%tax is 46.87%

If an firms return fell into zero, his return on equity will be zero.