Question

Last year coral gables corp had $410,000 of assets, $403,000 of sales, $28,250 of net income, and a total debt ratio of 39%. The new cfo believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets and total invested capital to $252,500. The firm finances using only debt and common equity. Sales, costs, and net income would not be affected, and the firm would maintain the same capital structure (but with less total debt). By how much would the reduction in assets improve the roe? Do not round your intermediate calculations

Answer 1

In order to find current return on equity we need to find equity , In order to find equity we may use the below logic.

Since 39% of the assets are financed by Debt, we can conclude that the remaining 61% of total assets are financed by equity. Thus, of $410000, 61% constitutes Equity, Which is $250100.

In order the find Return on Equity we may used the below formula:

Return on Equity=$\frac{Net Income}{Shareholders Capital}$

Return on Equity=$\frac{28250}{250100}$*100

Return on equity= 11.30%

In cash assets are reduced to $252500, and the firm expects to keep the same capital structure of 39:61, Amount of Debt will be $98475 and Equity will be $154025

Thus New Return on Equity will Be= $28250/$154025*100

Return on Equity=18.34%

Thus return on equity increases by 7% (Approximately).