A firm has an ROE of 6 a debtequity ratio of 5 a tax rate of

A firm has an ROE of 6%, a debt/equity ratio of .5, a tax rate of 20%, and pays an interest rate of 8% on its debt. What is its operating ROA? Please note the formula and show your calculations.

Solution

Operating Return on Assets = Operating profit (EBIT)/ Total Assets.

So in this question, we need to calculate EBIT and Total assets for desired answer.

Based on question, debt/equity = 0.5

=> If equity = 10, debt = 5

Total Assets = Debt + Equity = 15 ------> Requirement 1

ROE = 6%

Net Income/Equity = 6%

Net Income = 6% * Equity = 6% * 10 = $6

Given tax rate = 20%

Earning before tax * (1 - Tax rate) = Net Income

This means, Earnings before tax = Net Income/(1-tax rate) = 6/(1 - 0.20%) = $7.5

EBIT = Earnings before Tax + Interest Expense

Interest Expense = $5 * 8% = 0.4

EBIT = 7.5 + 4 = 7.9 --> Requirement 2

Operating ROA = 7.9/15 = 52.67%