Question

In: Accounting

Below is information for the year 2019 for Company A and Company B. Interest expense $400...

Below is information for the year 2019 for Company A and Company B.

Interest expense $400 $0

Tax expense (40%) $400 $400

Net income $600 $600

Ending balance of total asset $10,000 $10,000

Total debt $5,000 $0

Equity $5,000 $10,000

Required: Compute the following for Year 2019

(a) Return on assets for Company A and B

(b) Financial leverage ratio for Company A and B

(c) Times interest earned ratio, after necessary adjustments for Company A if it capitalized $100 interest costs in the pension obligation during the year.

(d) “Company A has used financial leverage to increase its return to its shareholders”. Comment on this statement.

Solutions

Expert Solution

(a) Return on Assets = Net Income / Total Assets

Particulars Company A ($) Company B ($)
1. Net Income 600 600
2. Total Assets 10,000 10,000
3. Return on Net Assets (1/2)*100 6 6%

(b) Financial Leverage Ratio = Total Debt / Shareholders Equity

Particulars Company A ($) Company B ($)
1. Total Debt 5,000 0
2. Total Equity 5,000 10,000
3. Financial Leverage (1/2) 1:1 0:10,000

(c) Times Interest Earned Ratio = (Net Income + Interest + Tax Expense) / Interest

Interest includes capitalised interest.

= (600+400+100+400) / (400+100)

= 1,500 / 500

= 3 times

(d) Financial Leverage refers to the extent of debt used in the capitalization of the company. Capital can be raised through Equity or Debt. Equity holders expect growth in the company and a long term return on their investment while debt holders expect a fixed sum of payment, namely the interest at the end of every period. At an ideal level of financial leverage, the company's return on equity increases. This is because interest is a tax saving expense while the return on equity is not. Let us consider the following 2 circumstances for better understanding of this concept:

Particulars Company A - Present Company B - Entirely financed by Equity
1. Total Assets 10,000 10,000
2. Debt 5,000 0
3. Equity (1-2) 5,000 10,000

Total Income of Company A = Net Income + Tax Expense + Interest

= 600 + 400 + 400 = 1,400

Particulars Company A - Present Company B - Entirely financed by Equity
1. Total Income 1,400 1,400
2. Less: Interest Expense (400) -
3. Earnings Before Tax (EBT) 1,000 1,400
4. Less: Tax Expense @ 40% on EBT (400) (560)
5. Net Income 600 840
6. Equity 5,000 10,000
7. Return on Equity (5/6)*100 12% 8.4%

Hence, the above calculation proves that A has used financial leverage to increase its return to its shareholders.


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