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 45%, which will result in annual interest charges of $600,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of $1,200,000 on sales of $15,000,000, and it expects to have a total assets turnover ratio of 4.0. Under these conditions, the tax rate will be 30%. 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

Preparing Income Statement:

• Sales = $15,000,000
• EBIT = $1,200,000
• Interest expense = $600,000
• EBT = EBIT - Interest expense = $600,000
• Taxes (30%) = $180,000
• Net income = $420,000

Net profit margin = Net income/Total sales = $420,000 / $15,000,000 = 0.028, or 2.80%

Asset turnover = 4

• Debt to assets ratio = 45% = 0.45
• Equity to assets ratio = 1 - 0.45 = 0.55

Leverage multiplier = 1 / equity to assets ratio = 1 / 0.55 = 1.82

ROE = Net profit margin x Asset turnover x Leverage multiplier

ROE = 2.80% x 4 x 1.82 = 20.36%