First case - 100% equity
Required assets = $2,000,000
Expected earnings = $2,000,000 * 30% = $600,000
Taxes @ 30% = $600,000 * 30% = $180,000.
Earnings after tax = $600,000 - $180,000 = $420,000.
ROE = $420,000/$2,000,000 = 21%
Second case - 35% debt
Debt = $2,000,000 * 35% = $700,000
Equity = $2,000,000 * 65% = $1,300,000
Earnings before interest and taxes = $2,000,000 * 30% =
$600,000.
Interest @ 12% = $700,000 * 12% = $84,000
Earnings before tax = $600,000 - $84,000 = $516,000.
Taxes @30% = $516,000 * 30% = $154,800
Earnings after tax = $516,000 - $154,800= $361,200.
ROE = $361,200 / 1,300,000 = 27.78%
The difference between two cases = 27.78% - 21% =
6.78%
RETURN ON EQUITY Commonwealith Construction (CC) needs $2 million of assets to get started, and it...
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