Question

You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL - ROEU?

	0% Debt, U		60% Debt, L
Expected unit sales (Q)	32,000		32,000
Price per phone (P)	$250.00		$250.00
Fixed costs (F)	$1,000,000		$1,000,000
Variable cost/unit (V)	$200.00		$200.00
Required investment	$2,500,000		$2,500,000
% Debt	0.00%		60.00%
Debt, $	$0		$1,500,000
Equity, $	$2,500,000		$1,000,000
Interest rate	NA		10.00%
Tax rate	35.00%		35.00%

a. 12.56%

b. 13.65%

c. 11.33%

d. 15.70%

e. 16.52%

Answer 1

CORRECT ANSWER : b : 13.65%

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