Question

Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be ​$500 comma 000​, operating costs to be ​$455 comma 000​, assets to be ​$400 comma 000​, and its tax rate to be 40​%. Under Plan​ A, Quigley’s balance sheet would be comprised of 25​% debt and 75​% ​equity, and the interest rate on the debt would be 3​%. Under Plan​ B, Quigley's balance sheet would be comprised of 60​% debt and 40​% ​equity, and the interest rate on the debt would be 8​%. ​ Sales, operating​ costs, assets, and the tax rate are not affected by amount of debt Quigley uses. Ignore​ non-debt liabilities such as accounts payable. Compute ROE under each alternative. Under Plan​ A, ROE​ = nothing​% ​(enter as percent rounded to 2​ digits) Under Plan​ B, ROE​ = nothing​% ​(enter as percent rounded to 2​ digits)

Answer 1

Answer:

Return on Equity

Plan A = 8.4%

Plan B = 9.68%

Explanation:

Provided information, we have

Sales = $500,000

Operating Cost = $455,000

Thus Profit before interest and taxes = $500,000 - $455,000 = $45,000

Total value of assets = $400,000

Under Plan A

Debt = 25% and Equity = 75%

Thus, debt = $400,000 $\times$ 25% = $100,000

Interest rate on debt = 3% = $100,000 $\times$ 3% = $3,000

Thus Income after interest but before taxes = $45,000 - $3,000 = $42,000

Less: Taxes @ 40% = ($16,800)

Income after taxes for equity = $25,200

Return on equity = $\frac{25,200}{300,000} \times 100 = 8.4$

Under Plan B

Debt = 60% and equity = 40%

Thus, debt = $400,000 $\times$ 60% = $240,000

Interest on debt = $240,000 $\times$ 8% = $19,200

Thus profit after interest = $45,000 - $19,200 = $25,800

Less: Taxes @ 40% = $10,320

Profit for equity = $15,480

Return on equity = $\frac{15,480}{160,000} \times 100 = 9.68$

Return on Equity

Plan A = 8.4%

Plan B = 9.68%