Question

Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 30%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 30% of its assets with debt, which will have an 8% 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 35% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 30% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

Sol :

Total assets = $2 million

Basic earning power ratio = 30%

Debt to assets ratio = 30%

Interest rate =8%

Tax rate = 35%

Now Basic earning power ratio = EBIT / total assets

30% = EBIT / $2 million

EBIT = $2 million x 30% = $600000

Now financing option available with CC are debt and equity

1) Debt = 30% of $2 million and Equity = 70% of $2 million

Debt = 2 million x 30% = $600000 and Equity = $2 million x 70% = $1400000

2) Equity = 100% of $2 million

= $2 million x 100% = $2000000

Tax rate = 35%

Interest rate = 8%

Preferred stock will not be use

Return on equity (ROE) in both option will be as follows

		Debt financing 30%	Equity financing 100%
	EBIT	$600,000	$600,000
Less	Interest 8% of debt	$48,000	$0
	EBT	$552,000	$600,000
Less	35% tax on EBT	$193,200	$210,000
	Net income	$358,800	$390,000
Divide	Equity (common stock)	$1,400,000	$2,000,000
	ROE	25.63%	19.5%

ROE = ($358800/$1400000) x 100 = 25.63% and ($390000/$2000000) x 100 = 19.5%

Now difference in ROE = 25.63 - 19.5 = 6.13%

Therefore ROE will increase in case of 30% debt financing.