Question

< Question 9 of 10 Check My Work eBook Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CC will own no securities, 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 a 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 25% tax rate on taxable income, what is the difference between CC's expected ROE if it finances these assets with 40% deb versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places. percentage points Check My Work

Answer 1

Basic Earning Power = EBIT/Total assets
EBIT = 2,000,000*20% = $400,000
	With Debt	No Debt
EBIT	400,000	400,000
Less: Interest	80,000	-
EBT	320,000	400,000
Less: taxes	80,000	100,000
Net Income	240,000	300,000
Equity	1,200,000	2,000,000
ROE	20.00%	15.00%
Difference in ROE	5.00%
Hence, the answer is 5 percentage points

B 1 Basic Earning Power = EBIT/Total assets 2 EBIT = 2,000,000*20% = $400,000 3 4 EBIT 5 Less: Interest 6 EBT 7 Less: taxes 8 Net Income 9 Equity 10 ROE 11 Difference in ROE 12 13 Hence, the answer is 5 percentage points With Debt No Debt 400000 400000 =2000000*40%*10% O =B4-B5 =C4-C5 =B6*25% =C6*25% =B6-B7 =C6-C7 =2000000*60% 2000000 =B8/B9 =C8/C9 =B10-C10