Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000, operating costs to be $265,000, assets (capital) to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a contract with existing bondholders the TIE ratio would have to be maintained at or above 4.0. Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure?
A) 3.71%
B) 4.08%
C) 4.48%
D) 4.93%
E) 5.18%

Question

Quizplus · Accepted Answer

Under Plan A, the TIE ratio would be 4.0, so the maximum amount of debt that could be used would be $100,000. The interest expense would be $8,800, and the EBIT would be $35,000. The ROE would be 17.5%.Under Plan B, the maximum amount of debt that could be used would be $125,000. The interest expense would be $11,000, and the EBIT would be $34,000. The ROE would be 17.0%.The change in the ROE would be 17.5% - 17.0% = 0.5%.