Question

17. A&M Inc. is presently 100 percent equity financed and has assets of $200 million. A&M’s net income is $24 million and the company is in 40% tax bracket. Currently, the company is able to borrow 15 percent perpetual debt, that is, debt has no maturity date. What amount of 15% perpetual debt would A&M have to borrow in order to increase it return on stockholder’s equity to 15%? (Points : 3.5)

       66.67 million
       100 million
       150 million
       125 million

Answer 1

Currently, Total Equity = Total Assets, since the company is 100% equity financed.

So, total equity = $200 mil.

Net Income = 24mil

ROE = Net Income/Total Equity

Net Income = Pretax Income * (1 - Tax Rate) = (EBIT - Interest Expense) * (1 - Tax Rate)

Current Net Income = $24 mil, and interest expense = 0

So, 24 mil = (EBIT - 0) * (1 - 40%)

EBIT = 24/60% = $40 mil

Now, assume we raise d amount of debt and replace equity with that. So amount of equity = 200 - d

So, interest expense = 0.15d

6 = 0.06d

d = 100

So, answer is $100 mil