Question

Commonwealth Construction (CC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 50% of its assets with debt, which will have an 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 40% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 50% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

Amount invested is $1 million

Earning power ratio is 20%

So EBIT is 200000$

Now if the amount is financed by 50% debt and 50% common stock then the ROE is

EBIT 200000

Less- intt 500000*7% = 35000

There fore EBT is 165000

Less tax @40% = 66000

Therefore EAT Is 99000

Therefore ROE = 99000*100/500000 = 19.8%

And if it financed all the funds with common stock then the ROE Is

EBIT = 200000

Less - tax@40% = 80000

EAT = 120000

Therefore ROE = 120000*100/1000000 = 12%

The difference between these two ROE is 19.8 - 12 = 7.80% that is answer