Daggy Corporation has the following simplified balance sheet: Cash $ 25,000 Current liabilities $200,000
Inventory 190,000
Accounts receivable 125,000 Long-term debt 300,000
Net fixed assets 360,000 Common equity 200,000
Total $700,000 Total $700,000
The company has been advised that their credit policy is too generous and that they should reduce their days' sales outstanding to 36.5 days (assume a 365-day year). The increase in cash resulting from the decrease in accounts receivable will be used to reduce the company's long-term debt. The interest rate on long-term debt is 10 percent and the company's tax rate is 30 percent. The tighter credit policy is expected to reduce the company's sales to $750,000 and result in EBIT of $70,000. What is the company's expected ROE after the change in credit policy?
A) 14.88%
B) 16.63%
C) 15.75%
D) 18.38%
E) 16.25%

Question

Quizplus · Accepted Answer

First, we need to calculate the reduction in accounts receivable resulting from the tighter credit policy:

Current accounts receivable = $125,000
Average daily sales = $750,000 ÷ 365 = $2,054.79
New accounts receivable = $2,054.79 × 36.5 = $75,000
Reduction in accounts receivable = $125,000 - $75,000 = $50,000

Next, we need to calculate the reduction in interest expense resulting from the use of the extra cash to pay down long-term debt:

Reduction in long-term debt = $50,000
New long-term debt = $300,000 - $50,000 = $250,000
Reduction in interest expense = $50,000 × 0.10 = $5,000

Now we can calculate EBIT and net income:

EBIT = $70,000
Interest expense = $250,000 × 0.10 = $25,000 - $5,000 = $20,000
Taxable income = $70,000 - $20,000 = $50,000
Net income = $50,000 × (1 - 0.30) = $35,000

Finally, we can calculate the new ROE:

ROE =Net income ÷ Common equity
ROE = $35,000 ÷ $200,000
ROE = 0.175 or 17.5%

Therefore, the best choice is C (15.75%).

Daggy Corporation Has the Following Simplified Balance Sheet: Cash