Question

Adams operates his $57500 firm using his own equity. Bob operates his firm with $28750 of his own money plus $28750 of debt at a cost of 5 percent interest. Calculate Adams's and Bob's return on equity if their respective businesses produce earnings before interest and tax of $7000. Assume perfect markets.

Answer 1

Answer:

Adam return on equity is 12.1%. while Bob return on equity is 19.3%

Explanation:

Given that:

Now,

For Adam:

Earnings before interest and taxes (EBIT) = Net income + Interest + Taxes

EBIT = $7000

The equity of shareholders = $57500

The number of debt by which Adams shows no interest expense and no tax expense as perfect market presumed is stated s follows:

ROE = Net income /Average Shareholder Equity

=$7000/$57500

=0.121739

Therefore, Adam return on equity is 12.1%

For Bob

The equity of shareholders = $28750

The expense (interest) = Debt * Interest rate

=$28750 * 0.05

= 1437.5

Thus

Net income = EBIT - Interest

= 7000 -1437.5

=5562.5

Now,

ROE = Net income /Average Shareholder Equity

=5562.5 /$28750

= 0.19347

=19.3%

Therefore, Bob return on equity is 19.3%