Question

For the coming year, Crane Inc. is considering two financial plans. Management expects sales to be $301,770, operating costs to be $266,545, assets to be $200,000, and its tax rate to be 25%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but the TIE ratio would have to be kept at 4.00 or more. Under Plan B the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure

Answer 1

Answer:

increase in ROE due to plan B = 26.44% - 20.55% = 5.89%

Explanation:

currently EBIT = $301,770 - $266,545 = $35,225

TIE ratio = EBIT / interest expense

Plan A:

interest expense = ($200,000 x 25%) x 8,8% = $4,400

TIE ratio = $35,225 / $4,400 = 8

net income (assuming no taxes) = $30,825

ROE = $30,825 / $150,000 = 20.55%

Plan B:

TIE ratio = 4 = $35,225 / interest expense

interest expense = $35,225 / 4 = $8,806.25

total debt = $8,806.25 / 8.8% = $100,071

equity = $99,929

net income = $35,225 - $8,806.25 = $26,418.75

ROE = $26,418.75 / $99,929 = 26.44%

increase in ROE due to plan B = 26.44% - 20.55% = 5.89%