Question

ou are considering a stock investment in one of two firms (NoEquity, Inc. and NoDebt, Inc.), both of which operate in the same industry and have identical operating income of $6.5 million. NoEquity, Inc. finances its $25 million in assets with $24 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc. finances its $25 million in assets with no debt and $25 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.

Calculate the net income and return on assets for the two firms. (Enter your dollar answers in millions of dollars. Round all answers to 2 decimal places.)

Answer 1

NoEquity, Inc.:

Interest expense = Debt * interest rate = $24 million * 10% = $2.4 million

EBT = Operating income - Interest expense = $6.5 million - $2.4 million = $4.1 million

Net income = EBT * (1 - tax rate)
= $4.1 million * (1 - 0.30)
= $2.87 million

Net income = $2.87 million

Return on asset = Net income / Total assets
= $2.87 million / $25 million
= 11.48%

Return on asset = 11.48%

NoDebt, Inc.:

EBT = Operating income - Interest expense = $6.5 million - 0 = $6.5 million

Net income = EBT * (1 - tax rate)
= $6.5 million * (1 - 0.30)
= $4.55 million

Net income = $4.55 million

Return on asset = Net income / Total assets
= $4.55 million / $25 million
= 18.20%

Return on asset = 18.20%