Question

Last year Rosenberg Inc. had $225,000 of assets, $48,775 of EBIT, and a debt-to-total-assets ratio of...

Last year Rosenberg Inc. had $225,000 of assets, $48,775 of EBIT, and a debt-to-total-assets ratio of 32%. Now suppose the new CFO convinces the president to increase the debt ratio to 48%. Sales and total assets will not be affected, but interest expenses would increase. The interest rate on the firm’s debt was 7.5%, and the tax rate was 35%. Assume that the interest rate and tax rate would both remain constant. By how much would the change in the capital structure improve the ROE?

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Answer #1

Dear Student,

Solution :

> Equity and Debt Position

Particulars 32% debt 48% Debt
Equity 153000 117000
Debt 72000 108000

> Calculation of Net Income available to equity shareholders

Particulars 32% Debt 48% Debt
EBIT 48775 48775
Less : Interest (5400)

(8100)
Profit before tax 43775 40675
Less: Tax (15321) (14236)
Profit After Tax 28194 26439
Divide : Equity 153000 117000
ROE 0.1843 or 18.43 % 0.2260 or 22.60%

Thus change in capital structure improves the ROE by 4.17 %.

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