Question

Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 50% of its assets with debt, which will have an 9% 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 30% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 50% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

Solution:
	Difference between CC's expected ROE = 7.70 %
Working Notes:
	Total assets = $3,000,000
	ROE when entirely financed by common stock
	Earnings before interest & taxes (EBIT) = 20% x total assets
		=20% x $3,000,000
		=$600,000
	EBIT	$600,000
	Less: Interest	$0
	EBT	$600,000
	Less: Taxes @ 30%	$180,000
	[$600,000 x 30% ]
	Net Income (EAT)	$420,000
	Return on Equity (ROE) = Net income /Value of Equity financed
		=$420,000/$3,000,000
		= 0.14
		=14%
ROE when 50% financed by common stock and 50% debt
	Earnings before interest & taxes (EBIT) = 20% x total assets
		=20% x $3,000,000
		=$600,000
	EBIT	$600,000
	Less: Interest	$135,000
	[$3,000,000 x 50% x 9% ]
	EBT	$465,000
	Less: Taxes @ 30%	$139,500
	[$600,000 x 30% ]
	Net Income (EAT)	$325,500
	Return on Equity (ROE) = Net income /Value of Equity financed
		=$325,500/($3,000,000 x 50%)
		= 0.217
		=21.7%
	Difference between CC's expected ROE = ROE at 50% debt - ROE at 100% Equity
		=21.70% - 14%
		=7.70%
Please feel free to ask if anything about above solution in comment section of the question.