JJ Corporation’s last year Return on Equity (ROE) was only 2.5 percent. Manageme
ID: 2665703 • Letter: J
Question
JJ Corporation’s last year Return on Equity (ROE) was only 2.5 percent. Management wants to improve Return on Equity (ROE), for this purpose they has developed a new plan and made following amendments:For new plan total debt ratio is of 55 percent, it will result in interest expense of Rs. 300,000 per year. Projected EBIT of Rs. 1,000,000 on sales of Rs. 15,000,000 and it expects to have a total assets turnover ratio of 2. Under these conditions, the tax rate will be 30 percent.
Required:
1. What will be the effect of new plan on company’s ROE?
2. Either management should consider new plan or not?
Explanation / Answer
Calculating the ROE using Du Pont model: From Debt ratio: Debt ratio = 0.55 Therefore, the company has $0.55 in debt for every $1 in assets. Therefore, there is $0.45 in equity (1-$0.55) for every $0.55 in debt. Debt-equity ratio = Total debt / Total equity = $0.55 / $0.45 = 1.2 Equity multiplier = 1 + Debt-equtiy ratio = 1 + 1.2 = 2.2 ROE = (Net income / Sales ) * (Sales / Assets) * (Assets / Total equity) = Profit margin * Total asset turnover ratio * Equity multiplier But Net income is calculated as: EBIT $1,000,000 (-) Interest $300,000 ----------------------------------- EBT $700,000 (-) Taxes 30% $210,000 --------------------------------- Net income $490,000 ------------------------------ ROE = ($490,000 / $15,000,000) * 2.0 * 2.2 = 0.03267 * 2.0 * 2.2 = 0.1437 or 14.37% The company's ROE will increase by 11.87% b) The company should take up the new plan as it is giving the higher ROE.Related Questions
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