Question

In: Finance

1) BigDebt firm and SmallDebt firm are identical except for their level of debt and the...

1) BigDebt firm and SmallDebt firm are identical except for their level of debt and the interest rates they pay on debt-BigDebt has more debt and pays a higher interest on that debt. Based on the data given below, what is the difference between two firms' ROEs?

Applicable to Both Firms

Assets              =          $400
EBIT               =          $100
Tax Rate = 35%

Firm BigDebt’s Data
Debt Ratio       =          45%
Interest Rate    =          12.5%

Firm SmallDebt’s Data
Debt Ratio       =          25%
Interest Rate    =          9.0%

options:

3.18%

22.9%

29.7%

4.25%

3.21%

Solutions

Expert Solution

We can calculate the diiference between the ROE's of both firms as follows

Formulas used in the excel sheet are

So, the Difference between the ROEs of Big Debt Firm and Small Debt firm comes out to be 3.18%. So, the correct answer is option (a).

Hope I was able to solve your concern. If you are satisfied hit a thumbs up !!


Related Solutions

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 AB and Firm YZ are identical except for their debt-to-total-assets ratios (D/TAs) and interest rates...
Firm AB and Firm YZ are identical except for their debt-to-total-assets ratios (D/TAs) and interest rates on debt. Each has $200,000 in assets, $40,000 EBIT, and a 40 percent marginal tax rate. Firm AB has a D/TA ratio of 40 percent and pays 7.5 percent interest on its debt, whereas YZ has a 60 percent D/TA ratio and pays 10 percent interest on debt. Each firm has 5,000 shares of common stock outstanding. Calculate each firm’s EPS and ROE (ROE...
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...
Assume that two firms, U and L, are identical in all respects except for one: Firm...
Assume that two firms, U and L, are identical in all respects except for one: Firm U is debt-free, whereas Firm L has a capital structure that is 50% debt and 50% equity by market value. Further suppose that the assumptions of M&M's "irrelevance" Proposition I hold (no taxes or transaction costs, no bankruptcy costs, etc.) and that each firm will have income before interest and taxes of $800,000. If the required return on assets, rA, for these firms is...
Everything you know about both companies is identical except for the salary and neither firm will...
Everything you know about both companies is identical except for the salary and neither firm will tell you your starting salary until AFTER you agree to work for them so you have no idea what you could get. The only thing each firm is willing to tell you is that "The average starting salary for the last 7 new hires was $50,000". 1) Considering that both have the same AVERAGE starting salary, and everything else is identical, is there any...
Cruz Corporation has $100 billion of debt outstanding. An otherwise identical firm has no debt and...
Cruz Corporation has $100 billion of debt outstanding. An otherwise identical firm has no debt and has a market value of $450 billion. Under the Miller model, what is Cruz’s value if the federal-plus-state corporate tax rate is 28%, the effective personal tax rate on stock is 17%, and the personal tax rate on debt is 29%? Enter your answer in billions. For example, an answer of $1.23 billion should be entered as 1.23, not 1,230,000,000. Round your answer to...
Modigliani-Miller argue that except for taxes, debt would have no impact on ‘firm’ value. What is...
Modigliani-Miller argue that except for taxes, debt would have no impact on ‘firm’ value. What is the basis of this argument? Why does it break down in reality?
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT