Question

(a) ABC is an all-equity financed firm with total asset of £200m. Corporate tax rate is 20%. The EBIT in the bad, normal and good year scenarios are £8 million, £12 million and £16 million respectively. Given that XYZ is an otherwise identical firm, but with £50m of its £200m assets financed with debt bearing an interest rate of 2%, calculate the ROE under the three scenarios for both firms.

(b) Briefly discuss whether the volatility of ROE matters to investors in light of

the results obtained for (a).

Answer 1

Part a)

The ROE for both the companies is calculated as follows:

ROE = Net Income/Total Equity

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ABC

		Scenarios
	Bad	Normal	Good
EBIT	8,000,000	12,000,000	16,000,000
Less Taxes	1,600,000	2,400,000	3,200,000
Net Income (A)	6,400,000	9,600,000	12,800,000
Total Equity (B)	200,000,000	200,000,000	200,000,000
ROE (A/B)	3.20%	4.80%	6.40%

_____

XYZ

		Scenarios
	Bad	Normal	Good
EBIT	8,000,000	12,000,000	16,000,000
Less Interest (50,000,000*2%)	1,000,000	1,000,000	1,000,000
EBT	7,000,000	11,000,000	15,000,000
Less Taxes	1,400,000	2,200,000	3,000,000
Net Income (C)	5,600,000	8,800,000	12,000,000
Total Equity (200,000,000 - 50,000,000)(D)	150,000,000	150,000,000	150,000,000
ROE (C/D)	3.73%	5.87%	8.00%

_____

Part b)

Based on the results in Part a), the volatility of ROE will not matter to investors. It is because the fluctuation in the ROE values can be attributed to business cycles. While during bad times, the ROE is low, it is high during good times. Also, there is no significant variation/volatility in the ROE values between bad, normal and good times. Therefore, it can be concluded that the investors will not driven by the volatility of ROE in the given case.