Question

Pacific Packaging's ROE last year was only 6%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 60%, which will result in annual interest charges of $602,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,190,000 on sales of $14,000,000, and it expects to have a total assets turnover ratio of 2.2. Under these conditions, the tax rate will be 40%. 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

Net Income

Net Income = (EBIT – Interest Expenses) x (1 – Tax rate)

= ($1,190,000 - $602,000) x (1 – 0.40)

= $588,000 x 0.60

= $352,800

Total Equity

Total Assets = Sales / Total asset turnover

= $14,000,000 / 2.20 Times

= $6,363,636.36

Total Equity = Total Assets x (1 - debt-to-capital ratio)

= $6,363,636.36 x (1 – 0.60)

= $6,363,636.36 x 0.40

= $2,545,454.55

Return on Equity (ROE)

Therefore, the Return on Equity (ROE) = [Net Income / Total Equity] x 100

= [$352,800 / $2,545,454.55] x 100

= 13.86%

Hence, the Return on Equity (ROE) will be 13.86%