Question

SO 124 Gourmet Foods To Go has the following financial information Financo Book Equity: $4,000,000 Tax Rate 26% EBIT: $500,000 Gourmet Foods decides to borrow $2,000,000 at a 7 interest rate and with the proceed buy back 2.000.000 worth of their stock. Calculate return on equity before and after the loan and buy-back is made

Answer 1

12-4]

Before

Return on equity = net income / book equity

net income = (EBIT - interest expense) * (1 - tax rate)

net income = ($500,000 - $0) * (1 - 26%)

net income = $370,000.

Return on equity = $370,000 / $4,000,000 = 9.25%.

After

Interest expense = loan amount * interest rate = $2,000,000 * 7% = $140,000.

net income = (EBIT - interest expense) * (1 - tax rate)

net income = ($500,000 - $140,000) * (1 - 26%)

net income = $266,400.

Book equity = $4,000,000 - $2,000,000 = $2,000,000.

Return on equity = $266,400 / $2,000,000 = 13.32%.