Question

Firms A and B are identical except for their level of debt and the interest rates they pay on debt.

Each has $2 million in assets, $400,000 of EBIT, and has a 40% tax rate. However, firm A has a debt-to-assets ratio of 50% and pays 12% interest on its debt.

While Firm B has a 30% debt ratio and pays only 10% interest on its debt.

Required:

a) Determine the return on equity for each firm.

b) Explain why Firm B pays lower interest.

(Please show your work part-by-part)

Answer 1

Solution :-

Return on Equity =	Net Income / Shareholders' Equity
Particulars	Firm A	Firm B
Net Income	168,000.00	204,000.00
Shareholders' Equity	1,000,000.00	1,400,000.00
Return on Equity	17%	15%

Working

Debt to Assets Ratio	Total Debts / Total Assets
Particulars	Firm A	Firm B
Debt to Asset Ratio	50%	30%
Assets	2,000,000.00	2,000,000.00
Debts	1,000,000.00	600,000.00
Interest Rate	12%	10%
EBIT	400,000.00	400,000.00
Less :- Interest	120,000.00	60,000.00
EBT	280,000.00	340,000.00
Less :- Tax @ 40%	112,000.00	136,000.00
Net Income	168,000.00	204,000.00

2. Reason of low payment of Interest by Firm B

• Firm B has used less debts to back their total asset and however they have more Shareholder's fund to support their total assets.
• Total Debt is lower by $400,000 in comparison to Firm A
• Lower Interest @ 10% while Firm A Interest Rate is 12%