Question

Pacific Packaging's ROE last year was only 4%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 50%, which will result in annual interest charges of $396,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,176,000 on sales of $12,000,000, and it expects to have a total assets turnover ratio of 2.8. 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

Answer = 23.66%

Explanation:

Using DU point equation:

ROE = profit margin × TA turnover × equity multiplier

= NI/Sales × sales/TA × TA/equity

Now we calculate net income

EBIT =. $1176000

- interest = $396000

EBT = $780000

- tax = . $273000

NI =. $507000

Now,

TA turnover = 2.8 = sales/TA

2.8 = $12000000/TA

TA = $4285714

D/A = 50% so, E/A = 50% and therefore

Equity multipler = TA/E

= 1/EA

= 1/0.5

=2

So now we can complete the DU point equation to determine ROE

= 507000/12000000 × 12000000/4285714 × 2

= 23.66%

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