5.7 ROE Sample Solution
Here is the solution for: 25/75, when EBIT = $40.
- We will set ROE as the outcome variable.
- ROE = NI / Equity = [(EBIT – i) (1 – T)] / Equity.
- Since Debt is 25%, Equity is $150.
- NOSO = (0.75) (10,000s.) = 7.5s.
- As Equity varies, so too will Interest Expense.
- The Tax Bracket (T), does not change, ceteris paribus, with variations in the Degree of Leverage (DOL) and Equity. Taxes remain 40%.
Once again, the calculation steps are:
| Calculations | Formulae | ||
| EBIT | $40 | Assumed | |
| (Int) | (6) | (0.12)(.25)($200) | (Int. Rate)(% Debt)(Total Capital) |
| EBT | 34 | 40-6 | EBIT – Int. = EBT |
| (T) | 13.6 | (34)(0.40) | (EBT)(T) |
| NI | 20.4 | 34 – 13.6 | EBT – T |
| ROE | 0.136 | 20.4 ÷ 150 | NI ÷ Eq |
| EPS | $2.72 | 20.4 ÷ 7.5 | NI ÷ NOSO |