Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $301,770, operating costs to be $266,545, assets 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 the TIE ratio would have to be kept at 4.00 or more. 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) 3.83%
B) 4.02%
C) 4.22%
D) 4.43%
E) 4.65%

Question

Quizplus · Accepted Answer

Under Plan A, the TIE ratio would be 4.00, which means that the interest expense would be $266,545 / 4.00 = $66,636. The EBIT would be $301,770 - $266,545 = $35,225. The net income would be $35,225 - $66,636 * (1 - 0.35) = $11,346. The ROE would be $11,346 / $200,000 = 5.67%.Under Plan B, the maximum debt that met the TIE constraint would be $266,545 / 3.00 = $88,848. The interest expense would be $88,848 * 0.088 = $7,834. The EBIT would be $35,225. The net income would be $35,225 - $7,834 * (1 - 0.35) = $29,623. The ROE would be $29,623 / $200,000 = 14.81%.The change in the ROE would be 14.81% - 5.67% = 9.14%.