Last year Hamdi Corp. had sales of $500,000, operating costs of $450,000, and year-end assets of $420,000. The debt-to-total-assets ratio was 17%, the interest rate on the debt was 7.5%, and the firm's tax rate was 35%. The new CFO wants to see how the ROE would have been affected if the firm had used a 50% debt ratio. Assume that sales, operating costs, total assets, and the tax rate would not be affected, but the interest rate would rise to 8.0%. By how much would the ROE change in response to the change in the capital structure?
Debt Ratio = 0.17 = Total Debt/Total assets = Total Debt/420,000
=> Total Debt = 420,000*.17 = 71,400
Interest on Debt = .075*71,400 = $5,355
Net Income = (1-Tax Rate)*(Sales - Operating cost - Interest on Debt) = ...
This solution provides step-by-step formula and calculations for determining the return on equity.