Question

Commonwealth Construction (CC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 35%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 60% of its assets with debt, which will have an 12% interest rate. If it chooses to use debt, the firm will finance using only debt and common equity, so no preferred stock will be used. Assuming a 30% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 60% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

If basic earning power ratio is 35% on $1 million assets, then EBIT is 350,000

If CC is financed by 60% debt, then the debt will be 60% of assets = 600,000 and 40% will be equity = 400,000

Interest expense on 600,000 at 12% rate = 72,000

Net income = (EBIT - Int)*(1-T) = (350000-72000) * 0.7 = 194,600

Thus ROE = Net income / equity = 194600/400000 = 49%

If CC is financed entirely by equity, then,

Net income = (EBIT - Int)*(1-T) = 350000*0.7 = 245,000

ROE = Net income / equity = 245000/1000000 = 25%

Difference between both ROE = 49%-25% = 24%