Answer:
Kindly check the because my below submission is water tight
Explanation:
First and foremost, we need to determine the net income for both companies bearing in mind that the for firm A interest expense is 12% of debt capital whereas debt capital is 50% of total capital of $180,000 since the debt ratio(debt/total capital) of firm of Firm A is 50% and 0% for Firm NA
EBIT=$40,000
tax rate=35%
Firm A:
Debt capital=50%*$180,000=$90,000
Equity=50%*$180,000=$90,000
interest expense=$90,000*12%
interest expense=$10,800
Earnings before tax=$40,000-$10,800=$29,200
net income=earnings before-tax*(1-tax rate)
net income=$29,200*(1-35%)
net income=$18,980
return on equity=net income/equity
return on equity=$18,980/$90,000
return on equity=21.09%
Firm NA:
Equity=$180,000
debt=0%
EBIT=$40,000
no debt, no interest expense
net income=$40,000*(1-35%)
net income=$26,000
return on equity=$26,000/$180,000
return on equity=14.44%
ROEA - ROENA=21.09%-14.44%=6.65%
