Muscarella Inc. has the following balance sheet and income statement data: The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.70, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change?

Question

Muscarella Inc. has the following balance sheet and income statement data:  The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.70, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change?

Quizplus · Accepted Answer

To calculate the change in ROE, we need to first calculate the current ROE and the new ROE after the stock buyback.

Current ROE = Net Income / Shareholders' Equity = 1,000,000 / 5,900,000 = 0.1695 or 16.95%
Current ratio = Current assets / Current liabilities = 2,550,000 / 950,000 = 2.68
In order to reach the industry average current ratio of 2.70, the amount of inventory will need to be reduced by $50,000 ($2,600,000 - $2,550,000).

After the stock buyback, the new shareholders' equity will be $4,900,000 ($5,900,000 - $1,000,000).

New current assets = $2,550,000 - $50,000 = $2,500,000
New current liabilities = $2,500,000 / 2.70 = $925,926
New long-term debt = $3,500,000 - $1,000,000 = $2,500,000

New ROE = Net Income / Shareholders' Equity = 1,000,000 / 4,900,000 = 0.204 or 20.4%

The change in ROE is:
Change in ROE = New ROE - Current ROE = 20.4% - 16.95% = 3.45%

Therefore, the answer is B) 4.50% (rounded to the nearest tenth).