Question

Pacific Packaging's ROE last year was only 2%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 40%, which will result in annual interest charges of $152,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $388,000 on sales of $4,000,000, and it expects to have a total assets turnover ratio of 2.7. Under these conditions, the tax rate will be 35%. If the changes are made, what will be the company's return on equity? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Lets find total asset first

Asset turnover ratio = 2.7

Asset turnover ratio = Total sales / Total asset

=2.7 = 4000000/Total asset

Hence total asset = 4000000/2.7

=148.1481.48 $

Now Total invested capital = Total asset as given

Thus total capital = 1,481,481.48 $

Now debt-to-capital ratio = 40%

Debt/Total capital = 40%

Debt = Total capital x 40%

= 1481481.48 x 40%

=5,92,592.59$

Thus equity = 1481481.48 - 592,592.59

= 888,888.89$

Statement showing Profit after tax

Particulars	Amount
EBIT	388000
Less: interest	152000
PBT	236000
Tax @ 35%	82600
PAT	153400

Now Return on equity = PAT/ Equity

=153400/888888.89

=0.1726

i.e 17.26%