Question

Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 15%. CC will own no securities, all of its income will be operating income. If it so chooses, CC can finance up to 35% of its assets with debt, which will have an 8% 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 35% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.

Answer 1

Given,

Basic Earning Power = 15%

Interest = 8%

Total assets = $ 30,00,000

Tax rate = 25%

Debt to asset ratio = 35%

EBIT = Total assets * Basic earning power

= $ 30,00,000 * 0.15

= $ 4,50,000

> level of debt and equity in both scenarios

100 % equity financing:
Equity = $ 30,00,000 * 100% = $ 30,00,000

Debt = $0

35% debt financing:

Debt = $ 30,00,000 * 35% = $ 10,50,000

Equity = $ 30,00,000 - $ 10,50,000 = $19,50,000

> ROE in both cases

	35% Debt financing	100% Equity financing
EBIT	$ 4,50,000	$ 4,50,000
(-) Interest [ 8%]	$ 84,000	$ 0
EBT ( EBIT - Interest)	$ 3,66,000	$ 4,50,000
(-) Tax [ 25%]	$ 91,500	$ 1,12,500
Net Income	$ 2,74,500	$ 3,37,500
Common equity	$ 19,50,000	$ 30,00,000
ROE ( Net income / Common equity)	14.08%	11.25%

Difference in ROE = ROE with debt 35% - ROE without debt

= 14.08% - 11.25%

= 2.83 %