Question

Last year Jandik Corp. had $250,000 of assets (which is equal to its total invested capital), $18,750 of net income, and a debt-to-total-capital ratio of 37%. Now suppose the new CFO convinces the president to increase the debt-to-total-capital ratio to 48%. Sales, total assets and total invested capital will not be affected, but interest expenses would increase. However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE?

Answer 1

Answer:

change in capital  to Improvement in ROE = 2.518%

Step-by-step explanation:

To calculate the improvement in ROE, calculate ROE for current capital structure  by using DuPont analysis.

$ROE = Return\ on\ Assets \times Equity\ Multiplier$

where

Return on Assets = Net Income / Total Assets

                             $= \frac{18,750}{250,000} = 0.075$

Equity Multiplier = Total Assets / Equity

                         

Equity = Total assets x (1 – debt to capital ratio)

           =  $250,000 x (1-37%)

          = $157,500

Equity Multiplier = Total Assets / Equity

                           $= \frac{250,000}{157500} = 1.58$

ROE =0.075 x 1.58 = 0.11904761 or 11.905%

ROE after change in capital structure:

Equity = Total assets x (1 – debt to capital ratio)

         = $250,000 x (1-48%) = $130,000

ROE = (18,750/250,000) x (250,000/130,000)

        = 0.1442307692307692 or 14.423%

change in capital  to Improvement in ROE = 14.423% - 11.905% = 2.518%