Question

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 30%, the interest rate on the debt was 8.2%, and the firm's tax rate was 37%. 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?

a.2.57%

b.2.86%

c.2.48%

d.3.14%

e.2.32%

Answer 1

Solution :

Here,

Particulars	Current	Proposed
Sales	303,225	303,225
Less : Operating cost	267,500	267,500
Less : Interest ( Working Note )	4,797	7,195.50
Income before Tax	30,928	28,529.50
Less : Tax @ 37%	11,443.36	10,555.92
Net income	19,484.64	17,973.58
Equity ( Working Note )	136,500	107,250
ROE	14.27%	16.75%

Therefore,

Change in ROE = 16.75% - 14.27%

Change in ROE = 2.48%

The answer is option ( c ) i.e., 2.48%

Working Note :

	Current	Proposed
Interest	195,000 * 0.30 * 0.082	195,000 * 0.45 * 0.082
Equity	195,000 * ( 1 - 0.30 )	195,000 * ( 1 - 0.45 )