Virtual University Of Pakistan
Assignment No. 01 Total Marks: 15
Question # 01
JJ Corporation’s last year Return on Equity (ROE) was only 2.5 percent. Management wants to improve Return on Equity (ROE), for this purpose they has developed a new plan and made following amendments:
For new plan total debt ratio is of 55 percent, it will result in interest expense of Rs. 300,000 per year. Projected EBIT of Rs. 1,000,000 on sales of Rs. 15,000,000 and it expects to have a total assets turnover ratio of 2. Under these conditions, the tax rate will be 30 percent.
Required:
1. What will be the effect of new plan on company’s ROE?
2. Either management should consider new plan or not?
NOTE: Show complete working for this in proper format
Question # 02
A textile company has Rs. 650,000 of debt outstanding and pays interest 65,000 annually on debt. Its annual sales are Rs. 3 million its tax rate is 35percent and its net profit margin on sales is 6 percent. Textile Company has applied for loan from bank. There is a conditionfrom bank for loan sanction, company has to maintain TIE ratio at least 4times, and otherwise bank will reject loan request.
Required:
1. Calculate Time Interest Earned Ratio (TIE).
2. By keeping in view your result, what do you think that bank will sanction loan on the basis of given condition of Time Interest Earned Ratio (TIE)?
Important Tips
1. This Assignment can be best attempted from the knowledge acquired after
watching video lecture no. 1 to lecture no 12 and reading handouts as well as
recommended text book).
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Solution:
Calculating the ROE using Du Pont model:
From Debt ratio:
Debt ratio = 0.55
Therefore, the company has $0.55 in debt for every $1 in assets. Therefore, there is $0.45 in equity (1-$0.55) for every $0.55 in debt.
Debt-equity ratio = Total debt / Total equity
= $0.55 / $0.45
= 1.2
Equity multiplier = 1 + Debt-equtiy ratio
= 1 + 1.2
= 2.2
ROE = (Net income / Sales ) * (Sales / Assets) * (Assets / Total equity)
= Profit margin * Total asset turnover ratio * Equity multiplier
But Net income is calculated as:
EBIT $1,000,000
(-) Interest $300,000
-----------------------------------
EBT $700,000
(-) Taxes 30% $210,000
---------------------------------
Net income $490,000
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ROE = ($490,000 / $15,000,000) * 2.0 * 2.2
= 0.03267 * 2.0 * 2.2
= 0.1437 or 14.37%
The company's ROE will increase by 11.87%
b) The company should take up the new plan as it is giving the higher ROE.