Question

Last year Rennie Industries had sales of $395,000, assets of $175,000 (which equals total invested capital), a profit margin of 5.3%, and an equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $51,000 without affecting either sales or costs. The firm finances using only debt and common equity. Had it reduced its assets by this amount, and had the debt/total invested capital ratio, sales, and costs remained constant, how much would the ROE have changed? Do not round your intermediate calculations.

Answer 1

Answer: 5.9%

Explanation:

Before:

Equity is calculated as:

= Total Assets / Equity Multiplier

= $ 175,000 / 1.2

= $ 145,833

Therefore, ROE will be:

= (Turnover × Profit Margin) / Equity

= ($ 395,000 × 5.3%) / $ 145,833

= $ 20935 / $145,833

= 0.1436

= 14.36%

After:

New Total Assets will be:

= $ 175,000 - $ 51,000

= $ 124,000

Equity

= Total Assets / Equity Multiplier

= $ 124,000 / 1.2

= $ 103,333

ROE will then be:

= (Turnover × Profit Margin) / Equity

= ($ 395,000 × 5.3%) / $ 103,333

= $ 20935 / $ 103,333

= 0.2026

= 20.26%

Therefore, the change in ROE will be:

= 20.26% - 14.36%

= 5.9%

= 4.035%