Question

EE eBook Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 30%. 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 11% 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. 15.17 percentage points Hide Feedback Incorrect

Answer 1

Step - 1 Calculation of EBIT EBIT = Assets * Earnings power ratio = 2000000 * 30% = $ 600,000.00 Step - 2 Calculation of ROE if debt financed 35% Debt = 2000000 * 35% = $ 700,000.00 Equity = 2000000 - 700000 = $1,300,000.00 Interest expense = 700000 * 11% = $ 77,000.00 Net income = (EBIT - Interest)*(1-tax) = (600000 - 77000)*(.75) = $ 392,250.00 ROE = Net Income / Equity = 392250 /1300000 30.17% Step - 2 Calculation of ROE if fully financed by equity Equity = 2000000 Net Income = EBIT *(1 - tax) = 600000*(1-.25) = $ 450,000.00 ROE = Net Income / Equity = 450000/1300000 34.62% Difference between ROE = (34.62%-30.17%) = 4.45%