Question

Commonwealth Construction (CC) needs $2 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 60% of its assets with debt, which will have an 10% 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 35% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 60% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

BEP = EBIT / Total Assets

0.20 = EBIT / $2,000,000

EBIT = 0.20 x $2,000,000 = $400,000

Debt = 0.60 x $2,000,000 = $1,200,000

At an 10% interest rate, Interest = $1,200,000 x 0.10 = $120,000

	No Debt	Debt(60%)
EBIT	$400,000	$400,000
Less: Interest	0	$120,000
EBT	$400,000	$280,000
Less: Taxes(35%)	$140,000	$ 98,000
Net Income	$260,000	$182,000

ROE = Net Income / Common Equity

ROE (No Debt) = $260,000 / $2,000,000 = 0.13, or 13%

ROE (60% Debt) = $182,000 / ($2,000,000 x 0.4) = 0.2275, or 22.75%

Difference in ROE = 22.75% - 13% = 9.75%