Question

No-Toxic-Toys currently has $250,000 of equity and is planning an $100,000 expansion to meet increasing demand for its product. The company currently earns $87,500 in net income, and the expansion will yield $43,750 in additional income before any interest expense.

The company has three options: (1) do not expand, (2) expand and issue $100,000 in debt that requires payments of 15% annual interest, or (3) expand and raise $100,000 from equity financing. For each option, compute (a) net income and (b) return on equity (Net Income ÷ Equity). Ignore any income tax effects. (Round "Return on equity" to 1 decimal place.)

	1		2		3
	Don’t Expand		Debt Financing		Equity Financing
Income before interest expense
Interest expense
Net income
Equity
Return on equity		%		%		%

Answer 1

ANSWER

	Don’t expand	Debt financing		Equity financing
income before interest expense	87,500	131,250	=87,500+43,750	131,250	=87,500+43,750
interest expenses	0	15,000	=100,000*15%	0
Net income	87,500	116,250		131,250
Equity	250,000	250,000		350,000	=250,000+100,000
Return on equity	35.0%	46.5%		37.5%

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