Question

Non-toxic-toys currently has $400,000 of equity and is planning a $160,000 expansion to meet increasing demand for its product. The company currently earns $100,000 in net income and the expansion will yield $50,000 in additional income before any interest expense. The company has 3 options; do not expand, expand and issue $160,000 in debt that requires 8% annual interest, or expand and raise $160,000 from equity financing.

For each of the 3 options compute a) net income, b) return on equity.

Answer 1

Option 1 : Do not expand

a) Net income = Current net income = $100,000

here, equity = $400,000

b) Return on equity = [ Net income / Equity ] * 100 = [ $100,000 / $400,000 ] * 100 = 25%

Option 2 : Expand and issue $160,000 in debt that requires 8% annual interest

a)

Additional income before interest expense	$50,000
(-) Interest expense [ $160,000 * 8% ]	( $12,800 )
Additional net income	$37,200
(+) Current net income	$100,000
Net income [ after issue of debt ]	$137,200

here, Equity = $400,000

b) Return on equity = [ Net income / equity ] * 100 = [ $137,200 / $400,000 ] * 100 = 34.3%

Option 3 : Expand and raise $160,000 from equity financing

a)

Additional income before interest expense	$50,000
(-) Interest expense	( $0 )
Additional net income	$50,000
(+) Current net income	$100,000
Net income [ after equity issue ]	$150,000

Here, Equity = current equity + new equity issue = $400,000 + $160,000 = $560,000

b) Return on equity = [ Net income / Equity ] * 100 = [ $150,000 / $560,000 ] * 100 = 26.79%