Question

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Commonwealth Construction (CC) needs $3 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 40% of its assets with debt, which will have a 9% 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 40% 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

BEP = EBIT/Total Assets

EBIT = BEP*Total Assets = 0.25 * $3,000,000 = $750,000

IF Debt = 40%, then

Value of Debt = wD * Total Assets = 0.40 * $3,000,000 = $1,200,000

Value of Equity = Total Assets - Value of Debt = $3,000,000 - $1,200,000 = $1,800,000

Net Income = [EBIT - Interest] * [1 - t]

= [$750,000 - (0.09 * $1,200,000] * [1 - 0.25]

= [$750,000 - $108,000] * 0.75

= $642,000 * 0.75 = $481,500

ROE = Net Income / Common Equity

= $481,500 / $1,800,000 = 0.2675, or 26.75%

IF Debt = 0%, then

Value of Debt = $0

Value of Equity = Value of Total Assets = $3,000,000

Net Income = [EBIT - Interest] * [1 - t]

= [$750,000 - (0.09 * $0] * [1 - 0.25]

= [$750,000 - $0] * 0.75

= $750,000 * 0.75 = $562,500

ROE = Net Income / Common Equity

= $562,500 / $3,000,000 = 0.1875, or 18.75%

Difference in ROE = 40% debt financing - 100% Equity financing

= 26.75% - 18.75% = 8.00%