Mr. Agirich has provided the following information and ratios for the Aggie Farm
ID: 2481104 • Letter: M
Question
Mr. Agirich has provided the following information and ratios for the Aggie Farms 20X0 operations:
Average Total Assets = $840,000
Average Total Liabilities = $395,000
Net Farm Income before taxes = $ 74,800
Interest Paid and accrued = $ 26,000
Income Taxes Paid = $ 9,000
Based on this information, what is the projected Rate of Return on Equity after taxes, re, for Aggie Farms in 20X1? (Assume that the tax rate, t, is 15% and the Rate of Return on Assets before taxes, ra, will continue as reflected for 20X0 and that the future cost of debt, i, will be 10%. Use the equation presented in class to calculate the projected re. Use the information above to calculate ra. Remember that Net Farm Income before taxes is from the Income statement and is after interest.
The projected Rate of Return on Equity after taxes is A. 12% B. 10% C. 15.3% D. 11.7% E. None of the above
Which of the following changes does not increase the rate of return on equity after taxes? A. Do a better job of merchandising credit B. Reduce leverage C. Make more profitable investments D. Adoption of new (improved) technologies E. None of the above
The projected Rate of Return on Equity after taxes is A. 5% B. 10% C. 15.3% D. 0.5% E. None of the above
Mr. Agirich feels he needs to increase re to 13.6%. If he cannot increase return on assets nor decrease interest cost or the tax rate, how much additional debt will he need to incur to achieve the desired rate level of profitability (use the same ra that was calculated previously)?
To achieve a re = to 13.6, the leverage ratio needs to be ? A. 1.5 B. 2.0 C. 2.5 D. 3.0 E. None of the above
How much additional debt will the farm need to incur to achieve a re = to 13.6? A. $890,000 B. $395,000 C. $495,000 D. $400,000 E. None of the above
Suppose Mr. Agirich borrows the additional money (problem 4). What is the projected re for Aggie Farms for 20X1, if Mr. Agirich projects the ra to be 5%? Keep everything else the same. The projected Rate of Return on Equity after taxes is A. 5% B. -4.3% C. 0% D. 0.5% E. None of the above
As leverage increases, the separation between the re increases for different rates of return to assets. A. True B. False
If the rate of return to assets is less than the interest rate, leverage accentuates losses in equity. A. True B. False C. It depends on the tax rate.
Explanation / Answer
1.The projected Rate of Return on Equity after taxes is Net Income(After-tax)= (74800+26000-(10%*395000))*0.85= 52105 Equity= 840000-395000 = 445000 ROE = 52105/445000= 0.117089888 ie. 11.70% 2. All increase the rate of return on equity after taxes. So, ANSWER is None of the above Reducing leverage is to reduce debt- interest charge decreases- profit increase, hence share of equity holders also increase. The rest 3 also improve profit. 3. ROA*Leverage(Asset/Equity)= ROE Suppose leverage as x ie. 0.0890*x=0.136 x=.136/0.0890 1.528089888 Answer: A 1.5 4.ANSWER: E None of the above Leverage ratio= Total Assets/Equity= 1.5 1.5=Total assets/445000 Total Assets= 445000*1.5=667500 So, new debt to maintain this ratio= 667500-445000=222500 5. The projected Rate of Return on Equity after taxes is Net Loss (1062500*5%)-(10%*617500)= -8625 Equity= Same 445000 ROE = (8625)/445000 -0.019382022 ie. -1.94% .ANSWER: E None of the above 6.As leverage increases, the separation between the re increases for different rates of return to assets. A. True As seen from above calculations,there is a wide diffrence in ROE (even Negative), for different ROAs , 8.9% & 5%., under increasing leverages. 7.If the rate of return to assets is less than the interest rate, leverage accentuates losses in equity. A. True Debt+ equity = Toatl assets. More debt means more leverage. More leverage means more interest charge. It is true that leverage magnifies profits and also losses- when the assets' return is more- as equity base is less- returns are shared by a few. When the assets' return is less- as equity base is less- losses are also pronounced.
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