Question

Compare ROEs of the following financing options for a business with $100,000 investment with

Earnings before interest and taxes = $10,000 Loan interest rate = 10% Tax rate = 20% Option 1: 100% equity financing

Option 2: 40% financed with equity and 60% with a long-term loan.

Which of the options would yield a higher return on equity? Explain and upload your calculations

Answer 1

Investment Required	$        100,000
	Option 1	Option 2
Equity	$        100,000	$        40,000	($100,000 * 40%)
Debt	$                   -	$        60,000	($100,000 * 60%)
Earnings Before Intrest and Taxes	$          10,000	$        10,000
Less: Interest on Debt @ 10% (Debt*10%)	$                   -	$           6,000	($60,000 * 10%)
Earnings Before Taxes	$          10,000	$           4,000
Less: Taxes @ 20% (EBT*20%)	$            2,000	$              800
Earnings After Taxes	$            8,000	$           3,200
Return on Equity (EAT/Equity)	8%	8%

Return on Equity is same under Both the Options.