Answer:
current EBIT = $225,000, net income = $225,000 x 0.79 = $177,750
EBIT under expansion = $225,000 x 1.4 = $315,000, net income = $315,000 x 0.79 = $248,850
EBIT under recession = $225,000 x 0.75 = $168,750, net income = $168,750 x 0.79 = $133,312.50
current equity = $500,000
equity under proposed structure = $500,000 - $150,000 = $350,000
interest expense per year under proposed structure = $150,000 x 8% = $12,000
net income current economy = ($225,000 - $12,000) x 0.79 = $168,270
net income economic expansion = ($315,000 - $12,000) x 0.79 = $239,370
net income economic recession = ($168,750 - $12,000) x 0.79 = $123,832.50
return on equity = net income / total equity
ROE under current structure:
- no change in the economy = $177,750 / $500,000 = 35.55%
- economic expansion = $248,850 / $500,000 = 49.77%
- economic recession = $133,312.50 / $500,000 = 26.67%
ROE under proposed structure:
- no change in the economy = $168,270 / $350,000 = 48.08%
- economic expansion = $239,370 / $350,000 = 68.39%
- economic recession = $123,832.50 / $350,000 = 35.38%
