Question

You have the following information about two firms, Debt Free, Inc. and Debt Spree, Inc. Both firms have the same prospects for sales and EBIT, and both have the same level of assets, tax rate and borrowing rate. They differ in their use of debt financing.

Scenario	Sales	EBIT
Bad year	200	24
Normal year	275	30
Good year	380	49

	Debt Free		Debt Spree
Total assets	250		250
Tax rate	35	%	35	%
Debt	0		150
Equity	250		100
Borrowing rate	16	%	16	%

Calculate the interest expense for each firm:

Interest expense for Debt Free            $

Interest expense for Debt Spree            $

Calculate the following items for each firm for each scenario (bad year, normal year, good year): return on assets (ROA), net profit, and return on equity (ROE). (Use a minus sign to indicate negative answers. Round your answers to 2 decimal places.)

	Debt Free				Debt Spree
Scenario	ROA		Net Profit	ROE		ROA		Net Profit	ROE
Bad year		%			%		%			%
Normal year		%			%		%			%
Good year		%			%		%			%

Answer 1

Interest expense = Debt*borrowing rate

• Debt Free = 0.00*16% = 0.00
• Debt Spree = 150*16% = 24.00

ROA = EBIT/Total Assets

	Debt Free			Debt Spree
Scenario	EBIT	Total Assets	ROA = EBIT/Total Assets	EBIT	Total Assets	ROA = EBIT/Total Assets
Bad	24.00	250.00	9.60%	24.00	250.00	9.60%
Normal	30.00	250.00	12.00%	30.00	250.00	12.00%
Good	49.00	250.00	19.60%	49.00	250.00	19.60%

Net Profit = (EBIT - Interest)*(1-tax)

	Debt Free					Debt Spree
Scenario	EBIT	Interest Expense	EBT = EBIT-Int	Tax @ 35%	Net Profit = EBT-tax	EBIT	Interest Expense	EBT = EBIT-Int	Tax @ 35%	Net Profit = EBT-tax
Bad	24.00	0.00	24.00	8.40	15.60	24.00	24.00	0.00	0.00	0.00
Normal	30.00	0.00	30.00	10.50	19.50	30.00	24.00	6.00	2.10	3.90
Good	49.00	0.00	49.00	17.15	31.85	49.00	24.00	25.00	8.75	16.25

ROE = Net Profit/Equity

	Debt Free			Debt Free
Scenario	Net Profit	Equity	ROE = Net Profit/Equity	Net Profit	Equity	ROE = Net Profit/Equity
Bad	15.60	250.00	6.24%	0.00	100.00	0.00%
Normal	19.50	250.00	7.80%	3.90	100.00	3.90%
Good	31.85	250.00	12.74%	16.25	100.00	16.25%

Therefore the final table will be:

	Debt Free					Debt Spree
Scenario	ROA		Net Profit	ROE		ROA		Net Profit	ROE
Bad year	9.60%	%	15.60	6.24%	%	9.60%	%	0.00	0.00%	%
Normal year	12.00%	%	19.50	7.80%	%	12.00%	%	3.90	3.90%	%
Good year	19.60%	%	31.85	12.74%	%	19.60%	%	16.25	16.25%	%

Kindly give a thumbs up!!