Question

Last year, K9 WebbWear, Inc. reported an ROE of 22 percent. The firm's debt ratio was 50 percent, sales were $20 million, and the capital intensity was 1.25 times. This year, K9 WebbWear plans to increase its debt ratio to 60 percent. The change will not affect sales or total assets, however, it will reduce the firm's profit margin to 10 percent Calculate the net income and profit margin for K9 WebbWear last year. (Enter your answer in millions of dollars rounded to 2 decimal places. Round your percentage answer to 2 decimal places.) Net income (last year) million Profit margin (last year) % By how much will the change in K9 WebbWear's debt ratio affect its ROE? ROE (this year) will %

Answer 1

ROE = Net Income / Total Equity = 22%, Debt Ratio = Debt / Total Assets = 50%, Sales = $ 20 million, Capital Intensity Ratio = Total Assets / Total Sales = 1.25,

Total Assets = Total Sales x 1.25 = 20 x 1.25 = $ 25 million

Total Debt = 50% of Total Assets = 0.5 x 25 = $ 12.5 million and Total Equity = 25 - 12.5 = $ 12.5 million

Net Income = Total Equity x ROE = 12.5 x 0.22 = $ 2.75 million

Profit Margin = (Net Income / Sales) x 100 = (2.75/20) x 100 = 13.75 %

New Debt Ratio = 60% of Total Assets, New Debt = 0.6 x 25 = $ 15 million, New Equity = 25 - 15 = $ 10 million

New Profit Margin = 10%, Net Income = 0.1 x Old Sales (as Sales and Assets Remain Unchnged) = 0.1 x 20 = $ 2 million

New ROE = (2/10) x 100 = 20 %

% Change in ROE = [(20-22)/22] x 100 = - 9.0909 % ~ -9.091 %

Hence, the ROE decreases by 9.09 % upon increasing the debt ratio to 60%.