Question

Exhibit 15.1 Zorn Corporation is deciding whether to pursue a restricted or relaxed working capital investment policy. The firm's annual sales are expected to total $4,400,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2. Refer to Exhibit 15.1. Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same. In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies

Answer 1

Answer:

difference between ROEs = 10.83% (restricted)  - 9% (relaxed) = 1.83%

Explanation:

total annual sales = $4,400,000

EBIT = $150,000

net income = $150,000 x (1 - 40%) = $90,000

restricted policy:

asset turnover = 2.5

sales = $3,740,000

EBIT = $135,000

net income = $81,000

assets = $3,740,000 / 2.5 = $1,496,000

equity = $1,496,000 x 50% = $748,000

ROE = $81,000 / $748,000 = 10.83%

relaxed policy:

asset turnover = 2.2

sales = $4,400,000

EBIT = $150,000

net income = $90,000

assets = $4,400,000 / 2.2 = $2,000,000

equity = $2,000,000 x 50% = $1,000,000

ROE = $90,000 / $1,000,000 = 9%

difference between ROEs = 10.83% - 9% = 1.83%