Question

Non-toxic-toys currently has $400,000 of equity and is planning a $160,000 expansion to meet increasing demand for its product. The company currently earns $100,000 in net income and the expansion will yield $50,000 in additional income before any interest expense. The company has 3 options; do not expand, expand and issue $160,000 in debt that requires 8% annual interest, or expand and raise $160,000 from equity financing. For each of the 3 options compute a) net income b) return on equity.

Answer 1

Answer:

1. $100,000 and 25%

2. $137,200 and 34.3%

3. $150,000 and 27%

Explanation:

1. It does not expand

    a. Net income= $100,000 (as given in the question)

    b. Return on equity= (net income)/(shareholder’s equity)

Shareholder’s equity= $400,000

Thus return on equity= 100000/400000 = 0.25  or 25%

2. It expands and issue $160,000 in debt

    a. Net income= $100000 + 50000 –  12800 (debt interest 8% of     $160000)

= $137,200

b. Return on equity= (net income)/(shareholder’s equity)

= 137200/400000

=0.343  or 34.3%

3. It expands and raises equity of $160000

a. Net Income= $100000 + 50000

= $150000

b. Return on equity= (net income)/(shareholder’s equity)

= 150000/(400000 + 160000)

Where ($560,000) 400000 + 160000 is shareholder’s equity

= 0.27 or 27%