Question

Aaron Levie is the co-founder of Box. Assume that his company currently has $250,000 in equity, and he is considering a $100,000 expansion to meet increased demand. The $100,000 expansion would yield $16,000 in additional annual income before interest expense. Assume that the business currently earns $40,000 annual income before interest expense of $10,000, yielding a return on equity of 12% ($30,000/$250,000). To fund the expansion, he is considering the issuance of a 10-year, $100,000 note with annual interest payments (the principal due at the end of 10 years).

Required

Using return on equity as the decision criterion, show computations to support or reject the expansion if interest on the $100,000 note is (a) 10%, (b) 15%, (c) 16%, (d) 17%, and (e) 20%.

What general rule do the results in part 1 illustrate?

Answer 1

STATEMENT SHOWING RETEURN ON EQUITY
			10%	15%	16%	17%	20%
Net income-Agregate			56000	56000	56000	56000	56000
Less: Interest expense-Aggregate			20000	25000	26000	27000	30000
Net Income for equity			36000	31000	30000	29000	26000
Equity			250,000	250000	250000	250000	250000
Return on equity			14.40%	12.40%	12%	11.60%	10.40%
General Rule:
When the cost of additional investmenet is equal to or more than the return it yield, the investment shall be rejected:
Here, the results is as follows:
Investment amount			100,000
Return on investment			16,000
Return on investment			16%
When the cost of investment is lesser than 16%, it is acceptable (i.e. Acceptable at 10% and 15%)
When the cost of investment is equal to or higher than 16%, it shall be rejected( i.e. reject at 16%, 17% and 20%)