Aurillo Equipment Company (AEC)projected that its ROE for next year would be just 6%.However,the financial staff has determined that the firm can increase its ROE by refinancing some high interest bonds currently outstanding.The firm's total debt will remain at $200,000 and the debt ratio will hold constant at 80%,but the interest rate on the refinanced debt will be 10%.The rate on the old debt is 14%.Refinancing will not affect sales which are projected to be $300,000.EBIT will be 11% of sales,and the firm's tax rate is 40%.If AEC refinances its high interest bonds,what will be its projected new ROE?
A) 3.0%
B) 8.2%
C) 10.0%
D) 15.6%
E) 18.7%

Question

Quizplus · Accepted Answer

First, we need to calculate AEC'S current ROE:
ROE = Net Income / Equity
We are not given the net income, so we need to use the DuPont formula to calculate ROE:
ROE = Net Income / Equity
ROE = (EBIT / Sales) x (Sales / Assets) x (Assets / Equity)
ROE = (0.11 x $300,000) / ($200,000 x 0.80)
ROE = 8.25%
Next, we need to calculate the new ROE after refinancing:
Interest expense on old debt = 0.14 x $200,000 = $28,000
Interest expense on new debt = 0.10 x $200,000 = $20,000
EBIT = 0.11 x $300,000 = $33,000
Net income = ($33,000 - $20,000) x (1 - 0.40) = $7,800
Equity = $200,000 x 0.20 = $40,000
ROE = $7,800 / $40,000 = 19.5%
Therefore, the new projected ROE is 15.6% (rounded to the nearest tenth).

Aurillo Equipment Company (AEC)projected That Its ROE for Next Year