Question

In: Accounting

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

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)

Solutions

Expert Solution

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%

Related Solutions

Firms ABC and XYZ are identical except for their use of debt and the interest rates...
Firms ABC and XYZ are identical except for their use of debt and the interest rates they pay. ABC has more debt and must pay a higher interest rate. Based on the data as shown below, how much higher or lower will ABC's ROE be versus that of XYZ, i.e., what is ROEABC – ROEXYZ? Applicable to Both Firms Firm ABC's & Data Firm XYZ's Data Assets $3,000,000 (same for both ) Debt ratio 70%(ABC COMP.) Debt ratio 20%(XYZ COM)...
Firms HD and LD are identical except for their use of debt and the interest rates...
Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD? Applicable to Both Firms Firm HD's Data Firm LD's Data Assets $3,000,000 Debt ratio 80% Debt ratio 30% EBIT $500,000 Int. rate 14% Int. rate 12%...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt.
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $23 million in invested capital, has $4.6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 12% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure.Calculate...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt.
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $18 million in invested capital, has $5.4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 11% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure.Calculate...
The firms AA and BB are identical except for their D/A ratios and interest rates on...
The firms AA and BB are identical except for their D/A ratios and interest rates on debt. Each has $50 million in assets, earned $4 million before interest and taxes and has a 40% federal-plus-state tax rate. Firm AA, however, has 1- E/A ratio of 50% and pays 12% interest on its debt, whereas BB has a Wd of 30% and pays only 10% interest on debt. a. Calculate the rate of return on equity for both firms. b. Observing...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $24 million in invested capital, has $6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 11% interest on its debt, whereas LL has a 20% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure....
Firms HL and LL are identical except for their financial leverage ratios and the interest rates...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $12 million in invested capital, has $1.8 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 45% and pays 12% interest on its debt, whereas LL has a 25% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure....
Firms HL and LL are identical except for their financial leverage ratios and the interest rates...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $23 million in invested capital, has $4.6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 55% and pays 13% interest on its debt, whereas LL has a 35% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure....
Firms HL and LL are identical except for their financial leverage ratios and the interest rates...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $21 million in invested capital, has $4.2 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 60% and pays 11% interest on its debt, whereas LL has a 25% debt-to-capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure....
Firms HL and LL are identical except for their financial leverage ratios and the interest rates...
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $26 million in invested capital, has $3.9 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 55% and pays 11% interest on its debt, whereas LL has a 25% debt-to-capital ratio and pays only 8% interest on its debt. Neither firm uses preferred stock in its capital structure....
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT