Question

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%

Answer 1

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)