Question

1. If the

debt

-

to

-

assets ratio is 50 percent, the interest rate on all debt is 8 percent, the tax rate is

50 percent, and the return on equity is 10 percent, then the ratio of earnings before interest and

taxes (EBIT) to total assets, or the basic earning power rati

o, must be

Answer 1

HI

Here debt/asset = 50% = 0.5

return on equity = 10%

return on equity = Net Income / equity

= (EBIT*(1-interest rate) - EBIT*(1-interest rate)*(1-tax rate))/asset* asset/equity

lets say net income =$1

tax rate = 50%

that means profit before tax = 1/(1-0.5) = 1/0.5 = $2

return on equity = 10%

that means net income/ equity =0.1

equity = 1/0,1 = $10

then debt = equity = $10

then interest = 10*8% = $0.8

that means EBIT = profit before tax + interest = 2 + 0.8 = $2.8

and since debt/ asset =0.5

hence asset = 10/0.5 = $20

Hence EBIT/ total asset = 2.8 / 20 = 14%

Thanks