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Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets of...

Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets of $195,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and the firm's tax rate was 25%. The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. By how much would the ROE change in response to the change in the capital structure?

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Answer #1

Operating income=Sales-operating costs=303225-267500=35725

Given, debt to assets ratio=27% which means that out of all assets 27% is funded by debt and 73% by equity.

Debt=27%*total assets=27%*195000=52650

Equity=73%*195000=142350

Interest cost=8.2%*debt=8.2%*52650=4317.3

Net profit before taxes=operating income-interest cost=35725-4317.3=31,407.7

Net profit=Net profit before taxes*(1-tax rate)=31407.7*(1-25%)=23,555.8

Return on equity=Net profit/Equity=23555.8/142350=16.5%

After debt ratio changes to 45%, debt=45%*195000=87,750

Equity=55%*195000=107,250

Return on equity=23555.8/107250=21.96%

Return on equity increased by 5.41% (21.96%-16.5%) after debt ratio increased to 45%

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