Question

Commonwealth Construction (CC) needs $1 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 35% of its assets with debt, which will have an 7% 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 35% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 35% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

Solution:
	The difference between CC's expected ROE		4.55%
			[17.55% - 13%]
	ROE when 35% debt	17.55%
	ROE when 100% equity	13%
Working notes:
	EBIT	$200,000
	[$1,000,000 x 20% ]
ROE when 35% debt
	EBIT	$200,000
	Less: Interest Expense	($24,500)
	[1,000,000 x 35% x 7%]
	EBT	$175,500
	Less: Tax @35%	($61,425)
	[$75,500 x 35%]
	EAT	$114,075
	ROE = Return on Equity = EAT /(1,000,000 x (100%-35%))
		=$114,075/650,000
		=0.1755
		=17.55%
ROE when 100% equity
	EBIT	$200,000
	Less: Interest Expense	$0
	EBT	$200,000
	Less: Tax @35%	($70,000)
	[$75,500 x 35%]
	EAT	$130,000
	ROE = Return on Equity = EAT /$1,000,000
		=$130,000/1,000,000
		=0.13
		=13%
Please feel free to ask if anything about above solution in comment section of the question.