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27 April, 00:25

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? a. 2.72%b. 2.59%c. 2.96%d. 3.22%e. 3.14%

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  1. 27 April, 00:34
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    b. 2.59%

    Explanation:

    The assets are 200,000

    For Plan A

    it will be 25% debt = 200,000 x 25% = 50,000

    and 75% equity = 200,000 x 75% = 150,000

    The debt will generate 8.8% interest expense

    50,000 x 8.8% = 4,400

    Income for the expected project under Plan A

    sales revenue 300,000

    operating cost 265,000

    EBIT 35,000

    interest expense 4,400

    EBT 30,600

    income tax 10,710

    Net income 19,890

    TE = times interest earned = EBIT / interest expense

    35,000 / 4,400 = 7,95 It achieve the requirement of 4.5 or above

    ROE for plan A net income / equity

    19,890/150,000 = 0,1326 = 13.26%

    Under Plan B

    We will take as much debt as we can until TIE = 4.5

    so:

    EBIT / interest expense = TIE

    35,000/interest expense = 4.5

    35,000/4.5 = 7.777,78

    This will be the interest expense for plan B

    Now we calculate net income:

    (EBIT - interest) x (1 - tax-rate) = net income

    (35,000 - 7,777.78) x (1-35%) = 17.694,443

    and for the ROE for plan B first, we need to check the capital structure:

    The interest expense are the 8.8% of the debt so

    debt x rate = interest expense

    interest expense / rate = debt

    7,777.78/0.088 = 88.383,86

    Asset = debt + equty

    200,000 = 88,383.86 + equity

    200,000 - 88,383.86 = equity = 111,616.14‬

    Now, we got the capital structure

    debt 88,383.86

    equity 111,616.14

    ROE for Plan B

    17,694.443 / 111,616.14 = 0,15852943 = 15.85%

    now we compare both ROE

    Plan A 13.26%

    Plan B 15.85%

    Difference 2.59%

    Using Plan B will increase the ROE for 2.59%
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