Appendix A Solutions to Self-Test Questions and Problems A-19
c. The incremental ROA is:
ROA! ∆______Pro! t
∆Sales
$ _______∆Sales
∆Assets
Using debt! nancing, the incremental pro! t associated with the investment is
equal to the incremental pro! t found in Part a minus the interest expense in-
curred as a result of the investment:
∆Pro! t! New pro! t " Old pro! t " Interest
! $135,000 " $50,000 " 0.10($400,000)
! $45,000
The incremental sales is calculated as:
∆Sales! P 2 Q 2 " P 1 Q 1
! $95(7,000) " $100(5,000)
! $665,000 " $500,000
! $165,000
ROA! ________$45,000
$165,000
$ $165,000________
$400,000
! 11.25%
The return on the new investment still exceeds the average cost of capital, so
the! rm should make the investment.
a. EBIT $4,000,000
Interest ($2,000,000 $ 0.10) 200,000
Earnings before taxes (EBT) $3,800,000
Taxes (35%) 1,330,000
Net income $2,470,000
EPS! $2,470,000/600,000! $4.1167
P 0! $4.1167/0.15! $27.44
b. Equity! 600,000 $ $10! $6,000,000
Debt! $2,000,000
Total capital! $8,000,000
WACC! wdrd(1 " T) # wcrs
! (2/8)(10%)(1 " 0.35) # (6/8)(15%)
! 1.625% # 11.25%
! 12.875%
c. EBIT $4,000,000
Interest ($10,000,000 $ 0.12) 1,200,000
Earnings before taxes (EBT) $2,800,000
Taxes (35%) 980,000
Net income $1,820,000
Shares bought and retired:
∆N! ∆Debt/P 0! $8,000,000/$27.44! 291,545
New outstanding shares:
N 1! N 0 " ∆N! 600,000 " 291,545! 308,455
New EPS:
EPS! $1,820,000/308,455! $5.90
New price per share:
P 0! $5.90/0.17! $34.71 versus $27.44
Therefore, Gentry should change its capital structure.
ST-3ST-3
