Question

You are considering a stock investment in one of two firms (AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have identical EBITDA of $16.6 million and operating income of $10.0 million. AllDebt, Inc., finances its $25 million in assets with $24 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. AllEquity, Inc., finances its $25 million in assets with no debt and $25 million in equity. Both firms pay a tax rate of 21 percent on their taxable income. Calculate the income available to pay the asset-funders' investment-(the debt holders and stockholders) and resulting return on assets for the two firms. (Enter your dollar answers in millions of dollars. Round all answers to 3 decimal places.) AllDebt AllEquity million million Income available for asset funders Return on asset-funders' investment

Answer 1

Solution:

Calculation of tax liabilities of two firms:-

Particulars	Alldebt ($ millions)	All equity ($ millions)
Operating income	10	10
Less: Interest	2.4 (i.e. $24m*10%)	-
Earnings before tax (operating income less interest)	7.6	10
Taxes @ 21% of earnings before taxes	1.596	2.1

Income available for asset funders (All debt)= Operating income less tax liabilities= 10-1.596= $8.404 million

Income available for asset funders (All equity)= Operating income less tax liabilities= 10-2.1= $7.9 million

Return on investment (all debt)= income available for asset funders/total assets= 8.404/25= 33.616%

Return on investment (all equity)= income available for asset funders/total assets= 7.9/25= 31.6%