Question

Fill in the table using the following information.

Assets required for operation: $4,000

Case A—firm uses only equity financing

Case B—firm uses 30% debt with an 8% interest rate and 70% equity

Case C—firm uses 50% debt with a 12% interest rate and 50% equity

What happens to the return on the stockholders’ equity as the amount of debt increases? Why did the rate of interest increase in case C?

Answer 1

Introduction:

The capital requirement for the firm can be raised with the help of debt, equity and preferred stock. The issue of debt for raising fund helps to save tax due to interest payment on the debt. However, tax on interest is not saved when fund is raised with the help of equity.

Completion of table:

The given table will be completed as follows:

Note 1:

There is no debt issued for case A. The debt issued for case B is 30%. The debt issue for case B will be 30% of $4,000. The debt issued for case C is 50%. The debt issue for case C will be 50% of $4,000.

Note 2:

There is no debt issued for case A and equity is 100%. Case A is 100% financed with equity. The equity issued for case B is 70%. The equity issue for case B will be 70% of $4,000. The equity issued for case C is 50%. The equity issue for case C will be 50% of $4,000.

Note 3:

There is no debt issued for case A and interest will not be payable. The interest paid for case B is 8% of $1,200 and for case C is 12% of $2,000.

Note 4:

The earnings before tax will be computed by deducting interest expense from earnings before interest and taxes.

Note 5:

Taxes will be payable at the rate of 40% on earnings before taxes.

Note 6:

Net earning is computed by deducting taxes from earnings before taxes.

Return on equity is computed by dividing net earnings on equity. The return on stockholders’ equity increases with the increase in debt but it will decrease at 50% debt financing as rate of interest increases. Hence, the return on shareholders’ equity will increase with increase in debt at same rate of interest. The rate of interest increased due to increase in debt amount. Firm uses 50% of debt in financing structure and it will increase the interest expense.

Answer 2

SOLUTION :

Assets = $4000 .

                                     Impact of Debt on return on equity 

 Particulars/ Case                A                     B                     C

      

Debt outstanding ($)            0                   1200                2000

Stockholders’ equity ($)   4000                2800                2000

EBIT     ($)                            400                  400                  400

Interest expense ($)               0            1200*0.08        2000*0.12

                                                                    =  96              = 240

EBT  ($)                               400                   304                  160

Taxes @40%    ($)              160                  121.6                  64

Net earnings ($)                 240                  182.4                  96

Return on equity (%)  240/4000 *100   182.4/2800*100   96/2000*100

                                           = 6%                = 6.51%             = 4.8 %

It can be seen from the table above, as the debt increases, ROE also increase first up-to some level  of debt which does not make the project too risky and interest rate either does not chang or changes moderately. When the project becoms very risky due to high leverage, the interest rate  increases  to compensate the risk to the loan provider. As a result interest amount rises considerably and as a result ROE declines.

(ANSWER).