Question

Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 10%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 55% of its assets with debt, which will have an 7% interest rate. If it chooses to use debt, the firm will finance using only debt and common equity, so no preferred stock will be used. Assuming a 40% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 55% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places. %

Answer 1

The difference between CC's expected ROE if it finances these assets with 55% debt versus its expected ROE if it finances these assets entirely with common stock is 3.67% as per below working

option vls. 1 Required: Given : Difference in ROE with 55% debt - 100% Equity option Total Assets - $2,000,000 Basic earning power ratio - 10% option - 55% Debt option 2 - 100% Equity Tux Rate - 40% ; Interest Rute - 7% solution - EBIT (Earnings Before Interest and Tax) = Toted Assets & Busic earning power ratio. - $ 2,000,000 X 10% $ 200,000 - Ерт (Euhnia Beyhe Tча) = EBIT - Interest Exch. - $ 200,000 - ($2,000,000 X55) X 7%) $ 123,000 - RUE under option = EBT : Equity x 100 = $133,000 = ($2,000,000 X45%.) x100 = 13.67% - ROE under option 2 = EBIT - Equity x 100 - $ 200,000 $ 2,000,000 X 100 10.00 2. Hence vis. the 100% difference in Equity option ss% deep debt option (13.67% - 10.00%) ROE with is 3.67%