ROA

i
. A fire has destroyed a large percentage of the financial records of the Carter Company. You
have the task of piecing together information in order to release a financial report. You have
found the return on equity to be 18 percent. If sales were $4 million, the debt ratio was 0.40,
and total liabilities were $2 million, what would be the return on assets (ROA)?

ii
. Q Corp. has a basic earnings power (BEP) ratio of 15 percent, a times interest earned (TIE)
ratio of 6, and total assets are $100,000. Its corporate tax rate is 40 percent. What is Q Corp.’s
return on assets (ROA)?

ROE
iii
. Austin & Company has a debt ratio of 0.5, a total assets turnover ratio of 0.25, and a profit
margin of 10 percent. The Board of Directors is unhappy with the current return on equity
(ROE), and they think it could be doubled. This could be accomplished (1) by increasing the
profit margin to 12 percent and (2) by increasing debt utilization. Total assets turnover will
not change. What new debt ratio, along with the new 12 percent profit margin, would be
required to double the ROE?

iv
. Southeast Packaging’s ROE last year was only 5 percent, but its management has developed a
new operating plan designed to improve things. The new plan calls for a total debt ratio of 60
percent, which will result in interest charges of $8,000 per year. Management projects an
EBIT of $26,000 on sales of $240,000, and it expects to have a total assets turnover ratio of
2.0. Under these conditions, the average tax rate will be 40 percent. If the changes are made,
what return on equity will Southeast earn?

v
. XYZ’s balance sheet and income statement are given below:

Balance Sheet:
Cash $ 50 Accounts payable $ 100
A/R 150 Notes payable 0
Inventories 300 Long-term debt (10%) 700
Fixed assets 500 Common equity (20 shares) 200
Total assets $1,000 Total claims $1,000

Income Statement:
Sales $1,000
Cost of goods sold 855
EBIT $ 145
Interest 70
EBT $ 75
Taxes (33.333%) 25
Net income $ 50

The industry average inventory turnover is 5, the interest rate on the firm’s long-term debt is
10 percent, 20 shares are outstanding, and the stock sells at a P/E of 8.0. If XYZ changed its
inventory methods so as to operate at the industry average inventory turnover, if it used the
funds generated by this change to retire long-term debt, and if sales, cost of goods sold, and
the P/E ratio remained constant, by how many percentage points would its ROE increase?
i. ROA Answer: a Diff: M

Equity multiplier = 1/(1 - D/A) = 1/(1 - 0.4) = 1.67.

ROE = ROA  Equity multiplier.

18% = (ROA)(1.67)
ROA = 10.8%.
ii
. ROA Answer: a Diff: M

EBIT
BEP = = 0.15.
TA
TA = $100,000.
EBIT = 0.15($100,000) = $15,000.
EBIT
TIE = = 6.
INT
EBIT $15,000
Int = = = $2,500.
6 6

Calculate Net income:

EBIT $15,000
Int 2,500
EBT $12,500
Tax (40%) 5,000
NI $ 7,500

NI $7,500
ROA = = = 7.5%.
TA $100,000

iii. ROE Answer: d Diff: T

Before: Equity multiplier = 1/(1 - D/A) = 1/(1 - 0.5) = 2.0.

ROE = (PM)(Assets turnover)(EM) = (10%)(0.25)(2.0) = 5%.

After: [ROE = 2(5%) = 10%]:

10% = (12%)(0.25)(EM)
EM = 3.33 = TA/TE = 3.33/1.00.

TA = TD + TE
3.33 = TD + 1.00
TD = 2.33.

Debt ratio = 2.33/3.33 = 0.70 = 70%.

iv. ROE Answer: d Diff: T

ROE = Profit Margin  TA Turnover  Equity Multiplier.

Set up an income statement:

Sales (given) $240,000
Cost na
EBIT (given) $ 26,000
Int (given) 8,000
EBT $ 18,000
Taxes (40%) 7,200
NI $ 10,800

Turnover = 2 = S/TA; TA = S/2 = $240,000/2 = $120,000.

D/A = 60%; so E/A = 40%; and, therefore, TA/E = 1/(E/A) = 1/0.4 = 2.50.
 Complete the Du Pont equation to determine ROE:
ROE = $10,800/$240,000  $240,000/$120,000  $120,000/$48,000
= 0.045  2  2.5 = 0.225 = 22.5%.

v. ROE Answer: d Diff: T

Current ROE = $50/200 = 25%.

If XYZ had the industry average inventory turnover, its inventory balance
would be
Sales $1,000
Inv. Turnover = 5 = =
Inv . Inv .
Inv. = $1,000/5 = $200.

Therefore, inventories would decline by $100.

If the $100 were used to retire debt, then XYZ would save $100(0.10) = $10
of interest charges.
The new income statement would be:
Sales $1,000.000
Cost of goods sold 855.000
EBIT $ 145.000
Interest 60.000
EBT $ 85.000
Taxes (33.333%) 28.333
Net income $ 56.667
Now we would have:
New ROE = $56.667/$200 = 28.33%.
Therefore, the ROE would increase by 28.33% - 25.00% = 3.33%.