Quigley Inc. is considering two financial plans for the coming year. Management

Question

Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000, operating costs to be $265,000, assets (which is equal to its total invested capital) to be $200,000, and its tax rate to be 35%. Under Plan A it would finance the firm using 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a contract with existing bondholders the TIE ratio would have to be maintained at or above 4.0. Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, total invested capital, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure?

****Can you show the steps on how you got the answer please?*****

Explanation / Answer

Calculation of Net income & ROE under Plan A

EBIT = Sales- operating costs = 300000 – 265000 = $35000

Total Funding required = $200000

Equity Component = 75% of 200000 = $150000

Debt Component = 25% of 200000 = $50000

Interest on Debt = 8.8% of 50000 = $4400

TIE ratio gives us the information that by how many times can a company cover its interest cost

So TIE ratio = EBIT/Interest Expense with a constraint that it should be 4.0 or above

TIE ratio = 35000/4400 = 7.95 (which meets our constraints)

Earning before Taxes = 35000 – 4400 = $30600

Earning after tax = 30600(1-0.35) = $19890

ROE = Earning after tax/Equity = 19890/150000 = 13.26%

Calculation of Net income & ROE under Plan B

Under plan B debt is to be increase to such level so that TIE is exactly = 4 because that is the maximum interest a company would pay according to the covenants

So, TIE = EBIT/Interest Expense

Or 4 = 35000/ Interest Expense

Or Interest Expense = $8750

Now Interest expense = Debt *8.8%

Or 8750 = Debt * 8.8%

Or Debt = $99432

So equity = 200000 – 99432 = $100568

Now EBIT = $35000

Earning before Taxes = 35000 – 8750 = $26250

Earning after tax = 26250(1-0.35) = $17062.50

ROE = 17062.50 / 100568 = 16.97%

Hence the ROE changes from 13.26% to 16.97%

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