Question

eBook Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 15%. CC will own no securities, all of its income will be operating income. If it so chooses, CC can finance up to 35% 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 25% tax rate on taxable income, what is the difference between CC's expected ROE if it finances these assets with 35% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places. percentage points

Answer 1

Solution-

Basic Earning Power = EBIT/Total assets
EBIT = 3,000,000*15% = $450,000
	With Debt	No Debt
EBIT	$ 450,000	$ 450,000
Less: Interest**	$84,000	-
EBT(EBIT-Interest)	$366,000	$450,000
Less: Taxes(EBT*25%)	$91,500	$112,500
Net Income	$274,500	$337,500
Equity	$1,950,000	$ 3,000,000
ROE(Net Income/Equity)	14.08%	11.25%
Difference in ROE	2.83%
Hence, the answer is 2.83 percentage points

**Interest=3,000,000*35%*8% =84,000