Last year Swensen Corp.had sales of $303,225, operating costs of $267,500, and year-end assets of $195,000.The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and the firm's tax rate was 25%.The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio.Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant.By how much would the ROE change in response to the change in the capital structure?
A) 2.48%
B) 2.76%
C) 3.06%
D) 3.40%
E) 3.74%

Question

Quizplus · Accepted Answer

Current debt ratio = Debt / Total assets = 27%
Current equity ratio = Equity / Total assets = 73%

Given: Debt ratio = 45%
Equity ratio = 55%

Net income = Sales - Operating costs - Interest expense(1 - tax rate)
Current interest expense = 0.27 * 195000 * 0.082 = $3,755.70
New interest expense = 0.45 * 195000 * 0.082 = $7,413.50

Net income for the current capital structure = 303,225 - 267,500 - 3,755.70(1 - 0.25) = $22,914.48
Net income for the new capital structure = 303,225 - 267,500 - 7,413.50(1 - 0.25) = $17,659.14

Current ROE = Net income / Equity = 22,914.48 / (0.73 * 195,000) = 17.33%
New ROE = Net income / Equity = 17,659.14 / (0.55 * 195,000) = 17.73%

The change in ROE due to the change in capital structure is 17.73% - 17.33% = 0.4% or 3.4%. Therefore, the answer is D.

Last Year Swensen Corp