Aurillo Equipment Company (AEC) projected that its ROE for next year would be just 6%.However, the financial staff has determined that the firm can increase its ROE by refinancing some high interest bonds currently outstanding.The firm's total debt will remain at R200,000 and the debt ratio will hold constant at 80%, but the interest rate on the refinanced debt will be 10%.The rate on the old debt is 14%.Refinancing will not affect sales which are projected to be R300,000.EBIT will be 11% of sales, and the firm's tax rate is 40%.If AEC refinances its high interest bonds, what will be its projected new ROE?

Question

Quizplus · Accepted Answer

First, we need to calculate AEC's current ROE based on the given information:

ROE = Net Income/Shareholder's Equity
ROE = (EBIT(1-Tax Rate))/Shareholder's Equity
ROE = (0.11 x 300,000(1-0.40))/(0.20 x 300,000)
ROE = 0.0667 or 6.67%

Next, we will calculate AEC's new ROE after refinancing the high interest bonds:

Interest expense on old debt = 0.14 x R200,000 = R28,000
Interest expense on new debt = 0.10 x R200,000 = R20,000
Interest savings = R28,000 - R20,000 = R8,000

EBIT = 0.11 x R300,000 = R33,000
Interest expense = R20,000
EBT = R13,000
Net Income = R13,000(1-0.40) = R7,800

New Shareholder's Equity = R300,000 x 0.20 = R60,000

New ROE = Net Income/New Shareholder's Equity
New ROE = R7,800/R60,000
New ROE = 0.13 or 13%

Therefore, AEC's projected new ROE after refinancing its high interest bonds would be 15.6%, which is option D.

Aurillo Equipment Company (AEC) Projected That Its ROE for Next