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, all of its income will be operating income. If it so chooses, CC can finance up to 40% of its assets with debt, which will have a 10% 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 25% tax rate on taxable income, what is the difference between CC's expected ROE if it finances these assets with 40% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places."

Answer 1

Answer: 10%

Explanation:

If CC finances with 40% debt.

Return on Equity = Net Income/ Equity

Equity = Assets * ( 1 - debt)

= 2,000,000 * ( 1 - 40%)

= $1,200,000

Debt will therefore be;

= 2,000,000 -1,200,000

= $800,000

Net Income = (Earnings before Tax and Interest - Interest) * (1 - Tax)

EBIT = Basic earning ratio of 30% = 30% * 2,000,000

= $600,000

Net Income = [600,000 - ( 800,000 * 10%)] * ( 1 - 25%)

= $390,000

Return on Equity = 390,000/1,200,000

= 0.33

= 33%

If CC finances entirely with common stock

Net Income = Earnings before Tax and Interest * (1 - Tax)

= 600,000 * ( 1 - 25%)

= $450,000

Return on Equity = Net Income/ Equity

= 450,000/2,000,000

= 0.23

= 23%

Difference between financing with 40% debt and financing entirely with equity

= 33% - 23%

= 10%