Question

Shirley Inc. is an all-equity company recently founded, and you are required to estimate its equity return. Simple Corp. is a competitor with assets very similar to those of Shirley. Simple's return on equity is 8.84%, its debt-to-equity ratio is 1 and it is kept constant. The interest rate paid by Simple is 1.50% and the corporate tax rate is 23%. What is the return on equity for Shirley? (a) 4.02%
(b) 4.23%
(c) 4.93%
(d) 5.17% answer is D

Answer 1

The above given interest rate of 1.5% has been assumed to be after tax interest rate

Simple Corp is a leveraged firm having ROE of 8.84% having equal amount of debt and equity

ROE of unlevered firm is ROE of levered firm (before interest cost) * equity (of levered firm) ÷ total assets (of levered firm)

Since Shirley is an all equity firm it need not incur any interest cost

ROE of Simple corp before interest cost is 8.84 + 1.5 = 10.34%

ROE of Shirley is 10.34 * 1 ÷ 2 = 5.17%