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 (which is equal to its total invested capital) to be $200,000, and its tax rate to be 35%. Under Plan A it would finance the firm using 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a contract with existing bondholders the TIE ratio would have to be maintained at or above 5.0. Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, total invested capital, 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? Do not round your intermediate calculations.

a. 1.52%

b. 2.31%

c. 1.85%

d. 1.68%

e. 2.03%

Answer 1

	Plan A	Plan B
Sales	300,000.00	300,000.00
Operating Costs	265,000.00	265,000.00
Operating Income	35,000.00	35,000.00
Less: Interest	4,400.00	7,000.00
Income before tax	30,600.00	28,000.00
Less: Tax	10,710.00	9,800.00
Net Income	19,890.00	18,200.00
Equity	150,000.00	120,454.55
ROE = Net Income/Equity	13.26%	15.11%
Change in ROE	1.85%
TIE Ratio = Operating Income/Interest
Hence, Maximum interest = 35000/5 = $7,000
Debt taken = 7000/8.8% = $79545.45
Hence, the answer is c.1.85%