Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 25%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 35% of its assets with debt, which will have an 9% 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 30% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 35% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.
Difference = ROE with Debt - ROE without Debt
EBIT = Total Assets * Basic Earnings Power
= $2,000,000 * 0.25 = $500,000
ROE = [(EBIT - Interest) * (1 - t)] / [Total Assets * Weight of Equity]
ROE without Debt = [$500,000 * (1 - 0.30)] / [$2,000,000 * 100%]
= $350,000 / $2,000,000 = 0.175, or 17.50%
ROE with Debt = [{$500,000 - ($2,000,000 * 0.35 * 0.09)} * (1 - 0.30)] / [$2,000,000 * (1 - 0.35)]
= [($500,000 - $63,000) * 0.70] / $1,300,000
= $305,900 / $1,300,000 = 0.2353, or 23.53%
Difference = 23.53% - 17.50% = 6.03%
Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have...
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...
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