Question

Last year Urbana Corp. had $600,000 in total assets, a net sale of 570,000, a net income of $40,000, and a debt-to-equity ratio of 50%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income to $55,000. Assume assets, sales, and debt ratio would not be affected. How would the cost reduction project improve the ROE? What is the ROE before and after adopting the new program?

Answer 1

The ROE for Urbana Corp. would improve from 10% to 13.75% as a result of the cost reduction achieved by the new computer program. The equity remains constant at $400,000, but the increased net income raises the ROE.

Step-by-step explanation:

To calculate the Return on Equity (ROE) for Urbana Corp., we need to use the formula ROE = Net Income / Shareholder's Equity. With a debt-to-equity ratio of 50%, assuming total assets equal total liabilities plus equity, and analyzing last year's figures, the equity can be calculated as follows:

• Debt-to-equity ratio = Debt / Equity
• 0.5 = (Total Assets - Equity) / Equity
• 0.5 = $600,000 / Equity - 1
• Equity = $600,000 / (1 + 0.5)
• Equity = $400,000

The ROE before the introduction of the new computer program:

• ROE = $40,000 / $400,000 = 0.1 or 10%

After the cost reduction, with a net income of $55,000:

• ROE = $55,000 / $400,000 = 0.1375 or 13.75%

Thus, the cost reduction project would improve the ROE from 10% to 13.75%, indicating a more efficient management of the company's equity in generating profits.