Question

ABC Company has €1.2 million in assets that are currently financed with 100% equity. The company's earnings before interest and tax is €300,000, and its tax rate is 30%. If ABC changes its capital structure (recapitalizes) to include 40% debt, what is ABC's return on equity (ROE) before and after the change? Assume that the interest rate on debt is 5%.    (Note: ROE = net income / shareholders’ equity

Answer 1

	Before	After
EBIT	€             3,00,000	€              3,00,000
Less: Interest (1,200,000*40%*5%)		€                 24,000
Profit before tax	€             3,00,000	€              2,76,000
Less: Tax @ 30%	€                 90,000	€                 82,800
Net Income	€             2,10,000	€              1,93,200
Share Holder equity	€        1,20,00,000	€            72,00,000
1,200,000*60%
ROE: Net income/Shareholder's Equity	0.0175	0.0268