Question

Err Company has a major lawsuit against them for unsafe products. It recognizes a huge liability in 2004 of $300 million. The effect of this liability is to decrease stockholders' equity by 50%. In 2005, the effect of recognizing this liability, all else equal, is:A. Return on net operating assets will increase dramatically
B. Return on net operating assets will decrease dramatically
C. Return on equity will increase dramatically
D. Return on equity will decrease dramatically

Answer 1

Answer:

C) Return on equity will increase dramatically

Explanation:

Return on equity (ROE) is a profitability ratio and it is calculated using the following formula:

ROE = net income/ shareholders' equity

If shareholders' equity is reduced by 50%, and the net income remains stable, then ROE should double.

For example, net profit = $100, shareholders' equity = $1,000

ROE = $100 / $1,000 = 0.10

If shareholders' equity is reduced by 50%, then the new ROE will be:

ROE = $100 / $500 = 0.20