Aurillo Equipment Company (AEC) projected that its ROE for next year would be just 6 percent. 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 percent, but the interest rate on the refinanced debt will be 10 percent. The rate on the old debt is 14 percent. Refinancing will not affect sales which are projected to be $300,000. EBIT will be 11 percent of sales, and the firm's tax rate is 40 percent. 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

To calculate the new ROE, we need to find the new net income and divide it by the new equity.

Current ROE = 6%

Total debt = $200,000
Debt ratio = 80% 
Equity = $50,000

Current net income = EBIT(1 - Tax rate) = 0.11($300,000)(1-0.4) = $19,800

After refinancing, the interest expense will be:

Old interest expense = 0.14($200,000) = $28,000
New interest expense = 0.10($200,000) = $20,000

Annual interest savings = $28,000 - $20,000 = $8,000

New net income = $19,800 + $8,000 = $27,800

New equity = Total assets - Total debt = $250,000 - $200,000 = $50,000

New ROE = $27,800/$50,000 = 15.6%

Aurillo Equipment Company (AEC) Projected That Its ROE for Next