Question

RETURN ON EQUITY Commonwealth Construction (CC) needs $1 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 45% 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 45% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

First case: 100% equity

Required assets = $1,000,000
Expected earnings = $1,000,000 * 10% = $100,000.
Taxes @ 40% = $40,000.
Earnings after tax = $100,000 - $40,000 = $60,000
ROE = $60,000 / $1,000,000 = 6%

Second case: 45% debt

Debt = $1,000,000 * 45% = $450,000.
Equity = $1,000,000 * 55% = $550,000.

Earnings before interest and taxes = $1,000,000 * 10% = $100,000
Interest @7% = $450,000 * 7% = $31,500.
Earnings before tax = $100,000 - $31,500 = $68,500
Taxes @40% = $27,400
Earnings after tax = $68,500 - $27,400 = $41,100.

ROE = $41,100 / $550,000 = 7.47%

The difference between two cases = 7.47% - 6% = 1.47%