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The firms AA and BB are identical except for their D/A ratios and interest rates on...

The firms AA and BB are identical except for their D/A ratios and interest rates on debt. Each has $50 million in assets, earned $4 million before interest and taxes and has a 40% federal-plus-state tax rate. Firm AA, however, has 1- E/A ratio of 50% and pays 12% interest on its debt, whereas BB has a Wd of 30% and pays only 10% interest on debt.

a. Calculate the rate of return on equity for both firms.

b. Observing that AA has a higher return on equity, BB’s treasurer decides to raise the 1-E/A ratio from 30 to 70%, which will increase BB’s interest rate on all debt to 15%. Calculate the new rate of return on equity for BB

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Expert Solution

The answer to part a and b is showed in following pictures:

jeff jeffy answered 2 years ago
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