Question

eBook Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CC w w w com will be operating income. If it so chooses, CC can finance up to 40% of its assets with debt, which will have a 125 interest rate. I chose to set the form a only debt and common equity, so no preferred stock will be used. Assuming a 25% tax rate on taxable income, what is the difference between expected ROE Trans 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 percentage points Save Conti

Answer 1

Basic Earning Power = EBIT / Total Assets
0.20 = EBIT / $3,000,000
EBIT = $600,000

If assets are financed through equity only:

Value of Equity = Total Assets
Value of Equity = $3,000,000

Net Income = (EBIT - Interest Expense) * (1 - Tax Rate)
Net Income = ($600,000 - $0) * (1 - 0.25)
Net Income = $600,000 * 0.75
Net Income = $450,000

Return on Equity = Net Income / Value of Equity
Return on Equity = $450,000 / $3,000,000
Return on Equity = 0.15 or 15.00%

If assets are financed through 40% debt and 60% equity:

Value of Equity = 60% * Total Assets
Value of Equity = 60% * $3,000,000
Value of Equity = $1,800,000

Value of Debt = 40% * Total Assets
Value of Debt = 40% * $3,000,000
Value of Debt = $1,200,000

Interest Expense = 12% * Value of Debt
Interest Expense = 12% * $1,200,000
Interest Expense = $144,000

Net Income = (EBIT - Interest Expense) * (1 - Tax Rate)
Net Income = ($600,000 - $144,000) * (1 - 0.25)
Net Income = $456,000 * 0.75
Net Income = $342,000

Return on Equity = Net Income / Value of Equity
Return on Equity = $342,000 / $1,800,000
Return on Equity = 0.19 or 19.00%

Difference between Return on Equity = 19.00% - 15.00%
Difference between Return on Equity = 4.00%