Windmere Corporation’s statement of financial position at December 31, 2016, appears as follows:
Cash................ $ 63,000
Other current assets......... 1,106,000
Capital assets (net) ......... 7,140,000
Total................ $8,309,000
Current liabilities......... $ 546,000
Long-term debt......... 1,400,000
Preferred shares......... 700,000
Share capital—common shares..... 2,100,000
Retained earnings......... 3,563,000
Total............... $8,309,000
For the year just ended, Windmere reported net income of $540,000. During the year, the company declared preferred dividends of $50,000 and common dividends of $300,000.
Required:
a. Calculate the following ratios for Windmere:
i. Return on assets, using net income in the calculation
ii. Dividend payout ratio
iii. Return on common shareholders’ equity
b. Assume that the company issued $1.4 million of common shares at the beginning of 2016 and paid off the long-term debt. By repaying the long-term debt and not incurring any interest expense, the company’s net income increased by $70,000.
i. What would the return on common shareholders’ equity be? (Hint: Remember that shareholders’ equity is affected by net income.)
ii. Would common shareholders be better or worse off?
iii. Does switching from debt to equity financing always have this effect on the return on common shareholders’ equity? Explain.
c. Assume that the long-term debt remains as shown on the statement of financial position and that the company issued an additional $700,000 of common shares at the beginning of 2016. The company used the proceeds to redeem and cancel the preferred shares.
i. What would the return on common shareholders’ equity be?
ii. Would shareholders be better or worse off?
iii. Does switching from preferred equity financing to common equity financing always have this effect on the return on common shareholders’ equity? Explain.