Question

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Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 40% of its assets with debt, which will have an 8% 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 40% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

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ACCOUNTS latest - Microsoft Excel (Product Activation Failed) View Add-Ins File Home Insert Page Layout Formulas Data Review - 2x % Cut Calibri Dr General -11AA = = = A Σ AutoSum : A Fill 2 Sort & Wrap Text Merge & Center - E Copy Paste Format Painter Clipboard BIU - D $ :.: Insert Delete Format % , Number Conditional Format Formatting as Table Styles Cell Styles 2 Clear Filter Editing Find & Select Font Alignment Cells for E0727 EL 1 709 EJ E K EM EN E O EP EQ ER Formula Bar Es 710 BASIC EARNING POWER = 711 712 713 714 715 EBIT/TOTAL ASSETS 20% = EBIT/3000000 EBIT = 3000000 X 20% EBIT = 600000 CASE 1 716 600000 717 718 719 720 721 722 IF FIRM IS ALL EQUITY FINANCED EBIT= INTEREST = EBT = TAX = NET INCOME 600000 180000 420000 EQUITY 3000000 [ EQUITY = TOTAL ASSETS] (100% EQUITY FINANCED] 723 724 725 ROE = 14.00% [420000/3000000] 726 727 FIFO CASH BUDGET ferences budget 45 days cycle ROE, BV MV ratio VARIANCE BEP, OL FL ratios DETROIT float B-S profit loss SALES BUDGET dupont DIFF ANALYSIS BO . * ovel 130% Rea _ 0 + C .E ENG 01-11-2019

ACCOUNTS latest - Microsoft Excel (Product Activation Failed) View Add-Ins File Home Insert Page Layout Formulas Data Review - 2x % Cut Σ AutoSum : A Calibri Dr General -11AA = = = A E Copy Paste Format Painter Clipboard Wrap Text Merge & Center - BIU - D $ :.: Insert Delete Format % , Number Conditional Format Formatting as Table Styles Cell Styles Fill 2 Clear Sort & Find & Filter Select Editing Font Alignment Cells - for E0728 ΕΙ ΕΙ ΕΚ EL EM EN LEO EPLEQ ERTESE CASE 2 Γ 727 728 729 730 731 40% DEBT AND 60% EQUITY TOTAL ASSETS DEBT = 40% = EQUITY = 60% = 3000000 1200000 1800000 732 733 734 735 EBIT= INTEREST = EBT = TAX = NET INCOME 600000 96000 [1200000 X 8%] 504000 151200 352800 736 737 738 739 EQUITY 1800000 740 741 742 ROE = 19.60% [352800/1800000] 743 ANSWER: DIFFERENCE IN ROE = 5.60% (19.60% -14%] 744 745 FIFO CASH BUDGET ferences budget 45 days cycle ROE, BV MV ratio VARIANCE BEP, OL FL ratios DETROIT float B-S profit loss SALES BUDGET dupont DIFF ANALYSIS BO . * ovel 130% Rea _ 0 + C .E ENG 01-11-2019