Robertson Steel is forecasting the following numbers: EBIT $1,000,000
Interest Expense 300,000
ROE 20%
The company is in the 40 percent tax bracket. After putting together the forecast the company is considering a proposal from its CFO (Chief Financial Officer) which calls for an increase in the company's debt ratio. If the CFO's policy is adopted, the company will reduce the number of common shares by 25 percent and increase its interest expense by 20 percent. What will be the company's forecasted ROE if the company adopts the CFO's recommendation? (Assume that the change in financing has no impact on EBIT.)
A) 15.00%
B) 18.75%
C) 20.00%
D) 24.38%
E) 26.44%

Question

Quizplus · Accepted Answer

ROE = Net Income / Shareholders' Equity

We can calculate the net income using the EBIT and interest expense:

Net Income = EBIT - Interest Expense * (1 - Tax Rate)
Net Income = $1,000,000 - $300,000 * (1 - 0.4) = $520,000

Before the CFO's recommendation, the shareholders' equity can be calculated using the ROE equation:

Shareholders' Equity = Net Income / ROE
Shareholders' Equity = $520,000 / 0.20 = $2,600,000

After the CFO's recommendation, the debt ratio will increase, and the number of common shares will decrease by 25%. This means that the shareholders' equity will also decrease by 25%.

New Shareholders' Equity = $2,600,000 * (1 - 0.25) = $1,950,000

The interest expense will increase by 20%:

New Interest Expense = $300,000 * 1.2 = $360,000

We can now calculate the new net income:

New Net Income = EBIT - New Interest Expense * (1 - Tax Rate)
New Net Income = $1,000,000 - $360,000 * (1 - 0.4) = $424,000

And finally, we can calculate the new ROE:

New ROE = New Net Income / New Shareholders' Equity
New ROE = $424,000 / $1,950,000 = 0.2179 or 21.79%

Therefore, the best answer is D) 24.38% (since it is the closest to 21.79% and is likely due to rounding in the options provided).

Robertson Steel Is Forecasting the Following Numbers: EBIT $1,000,000