Question

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Commonwealth Construction (CC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 25%. CC will own no securities, all of its income will be operating income. If it so chooses, CC can finance up to 30% of its assets with debt, which will have a 7% 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 25% tax rate on taxable income, what is the difference between CC's expected ROE if it finances these assets with 30% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

  percentage points =

Answer 1

Solution :-

Assets = $1 million

EBIT = assets x basic earning power ratio

= $ 1,000,000 x 25%

= $250,000

Part A :-

Financed by 60% debt

Equity = Assets x (1 - % of debt)

= $1,000,000 x (1 - 0.30)

= $700,000

Debt = $1,000,000 - $700,000

= $300,000

Net income = (EBIT – interest expense) x (1- tax rate)

= ( $250,000 - $300,000 x 7%) x ( 1 - 0.25 )

= $171,750

ROE = net income / Equity

= $171,750 / $700,000

= 24.54%

Financed entirely with equity

Equity = total assets = $1,000,000

Net Income = ( $250,000 - 0 ) x ( 1 - 0.25 )

= $187,500

ROE = net income/ Equity

= $187,500 / $1,000,000

= 18.75%

Difference = 24.54% - 18.75% = 5.79%

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