In year 0, SmoothCo has $50 million in cash and $50 million in inventory, financed by $100 million in equity. In year 1, the company records $100 million in revenue, $80 million in operating costs, and $10 million in litigation provisions for a case yet to be resolved. Based on the preceding data, build a balance sheet for year 1. Assume inventory remains constant and no dividends are paid. What is the return on equity in year 1? In year 2, the company records $100 million in revenue and $90 million in operating costs.
The case started in year 1 is resolved for $5 million in cash. Because management overestimated the amount of litigation charges, SmoothCo takes a $5 million gain in year 2. What is ROE in year 2? How is ROE distorted by the litigation expense?