Question

You need $300,000 to start a new company and you are currently analyzing 4 ways to raise the money. If you project $30,000 net income the first year, which plan would lead to the highest return on equity (ROE) the first year?
Plan 1: The company issues $300,000 worth of stock.

Plan 2: The company issues $250,000 worth of stock and borrows the remaining amount.

Plan 3: The company issues $200,000 worth of stock and borrows the remaining amount.

Plan 4: The company issues $150,000 worth of stock and borrows the remaining amount.

A. Plan 1

B. Plan 3

C. Plan 2

D. Plan 4

Answer 1

Amount Required : $300,000

Estimated net income : $30,000

Return On Equity : Net Income / Outstanding paid up capital.

So Lower the Paid up capital will result in Higher the Return on equity. If a company chooses the to go with high borrowings and low stocks it will have more net income available for its stock holders. Which will result in high Return on per $ of equity. So if we choose Plan 4, Paid up capital will be lower in all plans and as a result Return on Equity will be Highest.

Therefore in the above case PLAN 4 will lead to the Highest return on equity (ROE) the first year.

So correct answer is Option D.

For any query please ask in comment box, we are happy to help you. Also please don't forget to provide your valuable feedback. Thanks!