Last year Ann Arbor Corp had $155,000 of assets, $305,000 of sales, $20,000 of net income, and a debt-to-total-assets ratio of 37.5%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $33,000. Assets, sales, and the debt ratio would not be affected. By how much would the cost reduction improve the ROE?
A) 11.51%
B) 12.11%
C) 12.75%
D) 13.42%
E) 14.09%

Question

Quizplus · Accepted Answer

First, we need to calculate the initial ROE:
ROE = Net Income / Total Equity
We do not have information on equity, but we can use the debt ratio to calculate it:
Debt Ratio = Total Debt / Total Assets
0.375 = Total Debt / $155,000
Total Debt = $58,125
Total Equity = Total Assets - Total Debt = $155,000 - $58,125 = $96,875
ROE = $20,000 / $96,875 = 20.66%
Next, we calculate the new ROE with the cost reduction:
New Net Income = $33,000
New ROE = New Net Income / Total Equity
New ROE = $33,000 / $96,875 = 34.07%
The improvement in ROE is:
Improvement = New ROE - Initial ROE
Improvement = 34.07% - 20.66% = 13.42%
Therefore, the answer is D) 13.42%.

Last Year Ann Arbor Corp Had $155,000 of Assets, $305,000