In year 0, SmoothCo has $50 million in cash and $50 million in inventory, financed by $100 million in equity. In year 1, the company records $100 million in revenue, $80 million in operating costs, and $10 million in litigation provisions for a case yet to be resolved. Based on the preceding data, build an income statement and balance sheet for year
1. Assume inventory remains constant, no dividends are paid, and there are no taxes. What is the return on equity (ROE) in year 1? In year 2, the company records $100 million in revenue and $90 million in operating costs. The case started in year 1 is resolved for $5 million in cash. Because management overestimated the amount of litigation charges, SmoothCo takes a $5 million gain in year
2. What is ROE in year 2? How is ROE distorted by the litigation expense?