Last year Jandik Corp.had $250,000 of assets (which is equal to its total invested capital),$18,750 of net income,and a debt-to-total-capital ratio of 37%.Now suppose the new CFO convinces the president to increase the debt-to-total-capital ratio to 48%.Sales,total assets and total invested capital will not be affected,but interest expenses would increase.However,the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged.By how much would the change in the capital structure improve the ROE? Do not round your intermediate calculations.
A) 1.94%
B) 2.07%
C) 2.57%
D) 2.52%
E) 1.96%

Question

Quizplus · Accepted Answer

The increase in the debt-to-total-capital ratio will increase the financial leverage of the firm, which will lead to a higher return on equity (ROE). The increase in ROE can be calculated as follows:New ROE = (Net income / Total invested capital) * (1 + (Debt-to-total-capital ratio * (Interest rate - Tax rate)))= (18,750 / 250,000) * (1 + (0.48 * (0.10 - 0.35)))= 0.075 * (1 + (0.48 * (-0.25)))= 0.075 * (1 - 0.12)= 0.075 * 0.88= 0.066Therefore, the increase in ROE is 6.6%.

Last Year Jandik Corp