Question

Firms XD and YD are identical except for their level of debt and the interest rates they pay on debt--XD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROES? Applicable to Both Firms Firm XD's Data Firm YD's Data Assets $200 Debt ratio 50% Debt ratio 30% EBIT $40 Interest rate 12% Interest rate 10% Tax rate 35%

Answer 1

Answer:

Particulars	XD's Firm Data	YD's Firm Data
Assets	$200	$200
EBIT	$40	$40
Tax Rate	35%	35%
Debt Ratio	50%	30%
Interest Rate	12%	10%
Net Income After Tax See WN:1	$18.2	$ 22.1
Average Share Holders Equity	$100	$140
Return on Equity(ROE) Net Income/ Average Shareholders Equity	18.2%	15.78%

Answer Difference in ROE = 18.2-15.78

= 2.42

Working Note : I:

Calculation of Net Income After Tax

Particular	XDs	YDs
EBIT	$40	$40
Less: Interest ( $200* Debt Ratio* Interest Rate	$12	$6
EBT	$28	$34
Less: Tax Rate (35%)	9.8	11.9
Net Income	$18.2	$ 22.1