Question

Commonwealth Construction (CC) needs $2 million of assets to get started, and it expects to have a basic earning power ratio of 10%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 45% of its assets with debt, which will have an 9% 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 45% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

%

PLEASE LABEL ANSWER VERY CLEARLY

Answer 1

Answer:

ROE (with 45% debt) = 7.03%

ROE (with 100% Equity) = 6.50%

Difference between CC's expected ROE it finances these assets with 45% debt versus its expected ROE if it finances these assets entirely with common stock = 7.03% - 6.50% = 0.53%

Working:

$2,000,000 Total Assets Capital: 45% Debt 100%Equity 0% 45% $900,000 55% $1,100,000 Debt 100% $2,000,000 Equity 100% Equity 45% debt Basic earning power ratio 10% 10% $200,000 $200,000 EBIT (Basic earning power ratio Total assets) $81,000 $0 Interest (Debt * 9%) $119,000 $200,000 EBT $41,650 $70,000 $130,000 Tax at 35% $77,350 Net Income $1,100,000 $2,000,000 Equity ROE (net income/equity) 7.03% 6.50%