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Firms HD and LD are identical except for their use of debt and the interest rates...

Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD?

Applicable to Both Firms Firm HD's Data Firm LD's Data

Assets $3,000,000 Debt ratio 80% Debt ratio 30%

EBIT $500,000 Int. rate 14% Int. rate 12%

Tax rate 35%

a. 5.24%

b. 5.63%

c. 5.78%

d. 6.05%

e. 6.32%

Solutions

Expert Solution

Calculation of ROE of HD:

Debt = Total assets*80%

= 3,000,000*80%

= 2,400,000

Interest = debt*14%

= 2,400,000*14%

= 336,000

EBIT. =500,000

(-) Interest. =(336,000)

EBT. = 164,000

Tax rate@35%= (57,400) (164,000*35%)

Net Income. = 106,600

Equity = Total assets *(100%-Debt ratio)

= 3,000,000*(100%-80%)

= 3,000,000*20%

= 600,000

ROE = Net income/Equity

= 106,600/600,000*100

= 17.76%

Calculation of ROE LD:

Debt = 3,000,000*30%

= 9,00,000

Interest = 9,00,000*12% = 108,000

EBIT. = 500,000

(-) Interest. = (108,000)

EBT. = 392,000

(-) Tax @35% = (137,200)

Net Income. = 254,800

Equity = 3,000,000*(100%-30%)

= 2,100,000

ROE = 254,800/2,100,000*100

= 12.13%

ROEHD - ROELD = 17.76%-12.13%

= 5.63%

Answer : 5.63% (b)

jeff jeffy answered 1 year ago

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