Last year Kruse Corp had $305,000 of assets, $403,000 of sales, $28,250 of net income, and a debt-to-total-assets ratio of 39%. The new CFO believes the firm has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets to $252,500. Sales, costs, and net income would not be affected, and the firm would maintain the same debt ratio (but with less total debt). By how much would the reduction in assets improve the ROE?
A) 2.85%
B) 3.00%
C) 3.16%
D) 3.31%
E) 3.48%

Question

Quizplus · Accepted Answer

First, we need to calculate the current ROE:
ROE = Net Income / Shareholder's Equity
Shareholder's Equity = Total Assets - Total Debt
Total Debt = Debt-to-Total-Assets Ratio x Total Assets = 0.39 x $305,000 = $119,550
Shareholder's Equity = $305,000 - $119,550 = $185,450
ROE = $28,250 / $185,450 = 0.1525 or 15.25%

Next, we need to calculate the new ROE after the reduction in assets:
Total Assets = $252,500
Total Debt = Debt-to-Total-Assets Ratio x Total Assets = 0.39 x $252,500 = $98,475
Shareholder's Equity = $252,500 - $98,475 = $154,025
ROE = $28,250 / $154,025 = 0.1833 or 18.33%

The improvement in ROE is:
Improvement = New ROE - Current ROE = 0.1833 - 0.1525 = 0.0308 or 3.08%
Therefore, the correct answer is C, 3.16%.

Last Year Kruse Corp Had $305,000 of Assets, $403,000 of Sales