Question

Last year Urbana Corp. had $197,500 of assets, $307,500 of sales, $19,575 of net income, and a debt-to-total-assets ratio of 37.5%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $33,000. Assets, sales, and the debt ratio would not be affected. By how much would the cost reduction improve the ROE

Answer 1

Answer:

Increase in Return on equity = 10.876%

Explanation:

Given:

Assets = $197,500  

Sales = $307,500

Old net income = $19,575  

New net income = $33,000  

Debt-to-total-assets ratio = 37.5% = 37.5 / 100 = 0.375

Computation of total debt:

Debt-to-total-assets ratio = Debt / Assets

0.375 = Debt / $197,500

Debt = 74,063 (approx)

Equity-to-total-assets ratio = 1 - Debt-to-total-assets ratio

Equity-to-total-assets ratio = 1 - 0.375

Equity-to-total-assets ratio = 0.625

Computation of total Equity:

Equity-to-total-assets ratio = Equity / Assets

0.625 = Equity / $197,500

Equity =  $123,438 (approx)

Return on equity = (Net income / Equity) × 100

Return on equity (Old net income) = ($19,575 / $123,438) × 100

Return on equity (Old net income) = 15.858%

Return on equity (New net income) = ($33,000 / $123,438) × 100

Return on equity (New net income) = 26.734%

Increase in Return on equity = 26.734% - 15.858%

Increase in Return on equity = 10.876%