Corbin, Inc. had net income of $150,000 on sales of $5,000,000 during 2016. In addition, the firm's total assets were $2,500,000, and its capital structure is comprised of 40% debt and 60% equity. What was Corbin's return on equity in 2016?
A) 15%
B) 2.5%
C) 10%
D) Return on equity cannot be determined with the information provided.

Question

Quizplus · Accepted Answer

Return on equity (ROE) = Net Income / Average Shareholders' Equity

To find average shareholders' equity, we need to know the beginning and ending shareholders' equity. Unfortunately, this information is not provided in the question. However, we can use the balance sheet equation:

Total Assets = Total Liabilities + Shareholders' equity

We know that total assets were $2,500,000 and the capital structure is 40% debt and 60% equity. This means that total liabilities were 40% of $2,500,000, or $1,000,000, and shareholders' equity was 60% of $2,500,000, or $1,500,000.

Assuming there were no major changes in the capital structure during the year, we can estimate that average shareholders' equity was ($1,500,000 + Beginning Shareholders' Equity) / 2.

Using this estimate, we can calculate ROE:

ROE = $150,000 / (($1,500,000 + Beginning Shareholders' Equity) / 2)

ROE = $150,000 / ($750,000 + 0.5*Beginning Shareholders' Equity)

We do not know what the beginning shareholders' equity was, but we can still choose the closest option based on the information we have:

A) 15% - This is the most likely answer based on the information provided.
B) 2.5% - This is too low based on the amount of net income and shareholders' equity.
C) 10% - This is a possibility, but it assumes that the beginning shareholders' equity was $1,500,000 (no change during the year).
D) Return on equity cannot be determined with the information provided. - This option is not correct because we can estimate the ROE using the information provided.