Question

Jones June Bee's is currently unlevered with assets valued at $10,000. The company is considering changing its capital structure to 40% debt / 60% equity. If the company's EBIT is $4000, its cost of debt is 5%, and its tax rate is 35%, what is the levered ROE? Assume that the value of the firm does not change with the leverage.

Please answer using percentage format and round the nearest whole number (for example if your answer is 25%, enter only 25)

Answer 1

In this question, unlevered assets value = $10,000. Since company currently has only equity, value of equity = $10,000.

But with change of capital structure (and assuming no change in value of firm, as given in question), new capital structure will be: $4000 debt and $6000 equity.

Interest Expense = $4000 * 5% = $200

ROE = Net Income/Total Equity

Net Income = (EBIT - Interest Expense) * (1 - Tax Rate) = ($4000 - $200) * (1 - 35%) = $2,470

ROE = 2470/6000 = 41.17%

Hence ROE = 41%