Midwest Packaging\'s ROE last year was only 4%; but its management has developed

Question

Midwest Packaging's ROE last year was only 4%; but its management has developed a new operating plan that calls for a debt-to-assets ratio of 45%, which will result in annual interest charges of $539,000.  The firm has no plans to use preferred stock. Management projects an EBIT of $924,000 on sales of $11,000,000, and it expects to have a total assets turnover ratio of 3.6.  Under these conditions, the tax rate will be 40%.  If the changes are made, what will be the company's return on equity?

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Please show calculation. Thanks.

Explanation / Answer

Net income = (EBIT-interest)*(1-tax rate) = (924,000-539,000)*(1-40%) = 231,000

Total assets = sales/asset turnover ratio = 11,000,000/3.6 = 3,055,556

Equity = total assets*(1-debt/assets ratio) = 3,055,556*(1-45%) = 1680556

So ROE = net income/equity = 231,000/1680556 = 13.75%

Hope this helped ! Let me know in case of any queries.

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