Question

a local entrepreneur is looking for investors any new company that will develop mobile apps for behavioral health. The company requires a $15 million in start up funds. it can be capitalized with 100% of equity financing or with 30% debt and 70% equity. Expected operating income is $3 million and the company will pay taxes at a rate of 40%. Debt financing would bear and interest rate of 7%.

a. What would be the firm’s net income, total dollar return to investors, and ROE with 100% equity financing

b. What would be the firm’s net income, total dollar return to investors, and ROE with 30% debt financing and 70% Equity financing.

c. What factors should be investors consider when deciding on the appropriate capital structure?

Answer 1

a.
EBIT	$3,000,000
Less: Interest	$0
EBT	$3,000,000
Tax @ 40%	$1,200,000
Net Income	$1,800,000
In 100% equity financing, the total dollar return to investors would be $1,800,000
Formula to calculate return on equity
Return on equity = Net Income/Equity
Return on equity = 1,800,000/15,000,000
Return on equity	12.00%
b.
EBIT	$3,000,000
Less: Interest	$315,000	(15000000*30%*7%)
EBT	$2,685,000
Tax @ 40%	$1,074,000
Net Income	$1,611,000
In equity financing of 70% and debt of 30%, the total dollar return to investors would be $1,926,000 (315,000+1,611,000)
Formula to calculate return on equity
Return on equity = Net Income/Equity
Return on equity = 1,611,000/(15,000,000*70%)
Return on equity	15.34%
c.
The company should consider the cost of each capital and also consider the return it would provide to investors as with debt financing the return provided to equity shareholders would be higher than that under 100% equity financing
The company should also consider the risk of debt financing and whether company will have enough solvency to pay back its liabilities.