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Question about Change in ROE

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Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000, operating costs to be $265,000, assets to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a contract with existing bondholders the TIE ratio would have to be maintained at or above 4.5. Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure?

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Solution Summary

The solution explains how to determine the change ROE due to change in capital structure.

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We calculate the Net Income and ROE under the two plans
Plan A - The amount of equity is 75% of assets = 200,000 X 75% = 150,000
Amount of debt = 200,000 X 25% = 50,000
Interest cost = 50,000 X 8.8% = 4,400
The net ...

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