Question

Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 10%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 55% of its assets with debt, which will have an 9% 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 30% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 55% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

Gievn details:

Required return on Assets is 10%. It can be considered as WACC.

Debt Holders expectation will not be changed, They expect 9% as agreed. Equity Holders expectation will be changed consiedering many risks, Finance risk is one among them.

1. Expected ROE or Required Ke where Entirely funded by Equity:

WACC = [We * Ke] + [Wd * Kd ( 1 - tax rate)]

Where We, Wd is weight of equity and Weight of Debt respectively

Where Ke, Kd is Cost of equity and Weight of Debt respectively

here it is enitirely funded by Equity

10% = [1.00 * Ke] + [ 0* Kd ( 1 - 0.30) ]

10% = Ke

If entirely funded by Equity holders expected ROE is 10%

2. If funding is provided by equity & Debt FInance

WACC = [We * Ke] + [Wd * Kd ( 1 - tax rate)]

Where We, Wd is weight of equity and Weight of Debt respectively

Where Ke, Kd is Cost of equity and Weight of Debt respectively

10% = [0.45 * Ke] + [0.55 * 9% (1-0.30)]

= [0.45*Ke] + [0.55*6.30%]

10% = 0.45Ke + 3.465%

0.45 Ke = 6.535%

Ke = 14.52%

Equity holderes expected ROE is increased considering the finance risk resulting ffrom debt finance.

Pls comment, if any further clarification is required