Question

Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms' operations are identical ⎯they have the same total investor-supplied capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (w d). Based on the following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROE A − ROE NA? Applicable to Both Firms Firm A's Data Firm NA's Data Capital $150,000 wd 50% wd 0% EBIT $40,000 Int. rate 12% Int. rate 10% Tax rate 35% a. 10.51% b. 9.06% c. 8.60% d. 9.53% e. 10.01%

Answer 1

Calculation of ROE
	A	Firm NA
EBIT	40,000	40,000
Less: Interest	9,000	-
EBT	31,000	40,000
Less: Tax	10,850	14,000
Net Income	20,150	26,000
Equity	75,000	150,000
ROE = Net Income/Equity	26.87%	17.33%
Difference in ROE	9.53%
Hence, the answer is d.