Question

Repeat #2 A firm has EBIT of $15,800,000.00, total assets of $100,000,000.00, a tax rate of 40 percent, a cost of debt of 8.0 percent, and a debt/equity ratio of 1.00. As discussed in class, the ROE for a levered firm is also a function of a firm's return on assets (ROA) for an equivalent unlevered firm, plus a leverage effect, plus a tax shelter effect. Given the information above, determine what percentage of the firm's total return on equity arises from the tax shelter effect. 6 Answer: 22.60%

Can you show the steps/calculations?

Answer 1

As given in the question, we will have 2 scenarios here for Levered and Unlevered firm. In the unlevered firm, the assets will be financed through an all-equity financing i.e. there will be no debt and hence no interest expenses.

In a levered firm, the firm will have debt/equity ratio of 1:1, as mentioned in the question. Hence, it would be financed equally by debt and equity. Following will be capital structures in 2 scenarios

Levered Firm
Total Assets	10,00,00,000
Debt	5,00,00,000
Equity	5,00,00,000

Unlevered Firm
Total Assets	10,00,00,000
Equity	10,00,00,000

Now to explain the tax shelter effect, we'll calculate net income side by side for both cases:

	Levered Firm	Unlevered Firm	Explanation
Earnings before interest and tax (EBIT)	15800000	15800000	Data given
Less: interest	4000000	0	Interest charged at 8% on 5,000,000
Earnings before Taxes (EBT)	11800000	15800000	EBT=EBIT-Interest
Less: taxes	4720000	6320000	Taxes charged at 40% on EBT
Net income	7080000	9480000	Net Income=EBT-taxes

Tax shelter effect arises from the tax saved in the 2 scenarios:

Tax saved = 6320000-4720000 = $1,600,000

Percentage contribution to return on equity = Tax saved /net income of levered firm

= $1,600,000/$7,080,000 = 22.6%