Last year Chantler Corp. had $200,000 of assets, $20,000 of net income, and a debt-to-total-assets ratio of 30%. Now suppose the new CFO convinces the president to increase the debt ratio to 45%. Sales and total assets will not be affected, but interest expenses would increase. However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE?
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Last year Chantler Corp. had $200,000 of assets, $20,000 of net income, and a debt-to-total-assets ratio of 30%. Now suppose the new CFO convinces the president to increase the debt ratio to 45%. Sales and total assets will not be affected, but interest expenses would increase. However, the CFO believes that better cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged. By how much would the change in the capital structure improve the ROE?
ROE = Net income / Shareholders equity
Debt/ Total assets = 30% as given
30% = Debt/ 2,00,000
Debt = 30%*2,00,000
= 60,000
Shareholders equity = Total assets - Total liabilities
Shareholders equity = 2,00,000 - 60,000
= 1,40,000
ROE = 20,000 / 1,40,000
= 14.28%
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