A firm decides to use debt to raise its return on equity. It currently has sales
ID: 2648936 • Letter: A
Question
A firm decides to use debt to raise its return on equity. It currently has sales of $2 million, total assets of $1 million and a debt ratio of 20%. It's net profit margin has been 10% and it expects it to stay there into the future. If it borrows an additional $100,000 and invests in new equipment, what will be its new ROE given it has no change in the NPM and its sales increase by 5%? What was its original ROE? What is its new net income? A firm decides to use debt to raise its return on equity. It currently has sales of $2 million, total assets of $1 million and a debt ratio of 20%. It's net profit margin has been 10% and it expects it to stay there into the future. If it borrows an additional $100,000 and invests in new equipment, what will be its new ROE given it has no change in the NPM and its sales increase by 5%? What was its original ROE? What is its new net income?Explanation / Answer
As per original Case ROE
Sales = $100000
Total Assets: $1000000
Debt Ratio= 20%
Debt Ratio = Total Debt/ Total Assets
Total Debt= $200000
Shareholder equity= Total Assets- Total Debt
= $1000000-$200000
=$800000
Net profit margin= Net income/Sales
12%= Net Income/$100000
Net Income = $12000
Return on equity= Net Income/Shareholder equity
= $12000/$800000
= 1.5%
As per new Case ROE
where sales is increasing by 10% and investing $100000 for new equipment
we assumed that the debt ratio would be remain same i.e.20%
Sales = $110000
Total Assets: $1100000
Debt Ratio= 20%
Debt Ratio = Total Debt/ Total Assets
Total Debt= $20%*1100000= $220000
Shareholder equity= Total Assets- Total Debt
= $1100000-$220000
=$880000
Net profit margin= Net income/Sales
12%= Net Income/$110000
Net Income = $13200
Return on equity= Net Income/Shareholder equity
= $13200/$880000
= 1.5%
Net New income $ 13200
In both the cases ROE would be the same
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