Business – 10.4 Finance and accounting strategy – Accounting data and ratios | e-Consult
10.4 Finance and accounting strategy – Accounting data and ratios (1 questions)
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Assumptions: the £200,000 is used to purchase assets that generate the same return as existing assets (i.e., EBIT margin unchanged). The new debt carries 5% interest; equity carries no cost for ratio purposes.
| Scenario | Before | After Debt Issue | After Equity Issue |
| Total assets | £500,000 | £700,000 | £700,000 |
| Equity | £300,000 | £300,000 | £500,000 |
| Debt | £200,000 | £400,000 | £200,000 |
| EBIT (assumed 24% of sales) | £120,000 | £168,000 | £168,000 |
| Interest expense | £10,000 | £20,000 (old £10k + new £10k) | £10,000 |
| Operating profit after interest (NOPAT) | £110,000 | £148,000 | £158,000 |
| ROCE = NOPAT ÷ (Equity + Debt) | £110,000 ÷ £500,000 = 22.0% | £148,000 ÷ £700,000 = 21.1% | £158,000 ÷ £700,000 = 22.6% |
| Debt‑to‑Equity | £200,000 ÷ £300,000 = 0.67 | £400,000 ÷ £300,000 = 1.33 | £200,000 ÷ £500,000 = 0.40 |
Interpretation:
- Issuing debt slightly lowers ROCE (from 22.0% to 21.1%) because the additional interest reduces NOPAT relative to the larger capital base.
- Debt‑to‑Equity doubles, indicating a riskier capital structure.
- Issuing equity raises ROCE (to 22.6%) and improves the Debt‑to‑Equity ratio, reflecting a stronger, less leveraged position.