Question

Last year Jandik Corp. had $250,000 of assets (which is equal to its total invested capital), $18,750 of net income, and a debt-to-total-capital ratio of 37%. Now suppose the new CFO convinces the president to increase the debt-to-total-capital ratio to 48%. Sales, total assets and total invested capital will not be affected, but interest expenses would increase. However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE? Do not round your intermediate calculations.

		2.52%
		2.07%
		2.57%
		1.96%
		1.94%

Answer 1

old capital structure:

Total assets =250000

debt to total capital ratio = 37%

so debt = total assets * %

=250000*37% =92500

Equity amount = total assets - debt

=250000-92500

=157500

ROE formula = net income/equity

=18750/157500

=0.119047619 or 11.90%

New capital structure:

Total assets =250000

debt to total capital ratio = 48%

so debt = total assets * %

=250000*48% =120000

Equity amount = total assets - debt

=250000-120000

=130000

Net income would remain same. So

ROE =18750/130000

=0.1442307692 or 14.42%

Improvement is ROE = ROE under new structure - ROE under old structure

=14.42%-11.90%

=2.52%

So ROE will improve by 2.52%