Question

Frenza is planning an $160,000 expansion to launch a new product line. Frenza currently earns $100,000 in net income, and the new product line will yield $50,000 in additional income before any interest expense. Frenza has three options: (1) do not expand, (2) expand and issue $160,000 in debt that requires payments of 8% annual interest, or (3) expand and raise $160,000 from equity financing. For each option 1, 2, and 3, compute (a) net income and (b) return on equity (Net income ÷ Equity). Ignore any income tax effects. (Round "Return on equity" to 1 decimal place.) Show less 1 2 3 Don’t Expand Debt Financing Equity Financing Income before interest expense $92,000 Interest expense 0 12,800 0 Net income $100,000 Equity $400,000 $400,000 Return on equity % % %

Answer 1

Based on the current income to Frenza, and the proposed expansion amount, the net income and return on equity for the three options are:

Don't Expand:

• Net income = $100,000.
• Return on equity = 25%.

Debt financing:

• Net income = $137,200.
• Return on equity = 34.3%.

Equity financing:

• Net income = $150,000.
• Return on equity = 26.8%.

What happens if Frenza doesn't expand?

Net income will remain at $100,000.

Return on equity would be:

= Net income / Equity

= 100,000 / 400,000

= 25%

What happens if Frenza uses debt financing?

Income goes to $150,000.

Net income:
= Income - interest

= 150,000 - (8% x 160,000)

= $137,200

Return on equity:

= 137,200 / 400,000

= $34.3%.

What happens if Frenza uses equity financing?

Income goes to $150,000.

No interest payment so net income is $150,000.

Return on equity:

= 150,000 / (400,000 + 150,000 new equity)

= 26.8%

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