Task: Georgia Electric reported the following income statement and balance sheet for the previous year:
Balance sheet:
Assets Liabilities & Equity
Cash $ 100,000
Inventory 1,000,000
Accounts receivable 500,000
Current assets $1,600,000
Total debt $4,000,000
Net fixed assets 4,400,000 Total equity 2,000,000
Total assets $6,000,000 Total claims $6,000,000
Income Statement:
Sales $3,000,000
Operating costs 1,600,000
Operating income (EBIT) $1,400,000
Interest expense 400,000
Taxable income (EBT) $1,000,000
Taxes (40%) 400,000
Net income $ 600,000
The company’s interest cost is 10 percent, so the company’s interest expense each year is 10 percent of its total debt.
While the company’s financial performance is quite strong, its CFO (Chief Financial Officer) is always looking for ways to improve. The CFO has noticed that the company’s inventory turnover ratio is considerably weaker than the industry average which is 6.0. As an exercise, the CFO asks what would the company’s ROE have been last year if the following had occurred:
(Question 1) The company maintained the same level of sales, but was able to reduce inventory enough to achieve the industry average inventory turnover ratio.
(Question 2) The cash that was generated from the reduction in inventory was used to reduce part of the company’s outstanding debt. So, the company’s total debt would have been $4 million less the cash freed up from the improvement in inventory policy. The company’s interest expense would have been 10 percent of the new level of total debt.
(Question 3) Assume equity does not change. (The company pays all net income as dividends.)
Under this scenario, what would have been the company’s ROE last year?
a. 27.0%
b. 29.5%
c. 30.3%
d. 31.5%
e. 33.0%