Question

Q Search this course Ch 04: End-of-Chapter Problems - Analysis of Financial Statements 0 x < Back to Assignment Attempts: Keep the Highest: /1 10. Problem 4.16 Click here to read the eBook: Profitability Ratios RETURN ON EQUITY 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 55% of its assets with debt, which will have an 10% 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 35% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 55% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places. Grade i New Save & Continue Continue without saving

Answer 1

Equity = Total Assets * (1 - % of debt)

= $3,000,000 * (1 - 0.55) = $1,350,000

Basic Earnings Power Ratio = EBIT / Total Assets

0.20 = EBIT / $3,000,000

EBIT = 0.20 * $3,000,000 = $600,000

EBT = EBIT - Interest

= $600,000 - [$3,000,000 * 0.55 * 0.10] = $600,000 - $165,000 = $435,000

Net Income = EBT * (1 - t) = $435,000 * (1 - 0.35) = $282,750

ROE = Net Income / Equity = $282,750 / $1,350,000 = 0.2094, or 20.94%