Question

Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 25%. CC will own no securities, all of its income will be operating income. If it so chooses, CC can finance up to 40% of its assets with debt, which will have a 9% interest rate. If it chooses to use debt, the firm will finance using only debt and common equity, so no preferred stock will be used. Assuming a 25% tax rate on taxable income, what is the difference between CC's expected ROE if it finances these assets with 40% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places

Answer 1

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Answer:

Assets = $2 million

EBIT = assets x basic earning power ratio

         = $ 2,000,000 x 25%
         = $500,000

Part A financed by 40% debt

Equity = assets x (1- % of debt)

            = $2,000,000 x (1- 0.4)

            = $1,200,000

Debt = $2,000,000-1,200,000

          = $800,000

Net income = (EBIT – interest expense) x (1- tax rate)

                       = ($500,000 - $800,000 x 9% ) x (1-0.25)

=321,000

  

ROE = net income / Equity

         = 321000/1200,000

         = 26.75%

Financed entirely with equity

Equity = total assets = $2,000,000

Net Income = ($500,000-0) x (1-0.25)

                        = $375,000

ROE = net income/ Equity

         = $375,000 / $2,000,000

         = 18.75%

Difference = 26.75 - 18.75 = 8%