Question

Return on Equity

Central City Construction (CCC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 30%. CCC will own no securities, so all of its income will be operating income. If it chooses to, CCC can finance up to 35% of its assets with debt, which will have an 8% interest rate. Assuming a 40% tax rate on all taxable income, what is the difference between CCC's expected ROE if it financeswith 35% debt versus its expected ROE if it finances entirely with common stock? Round your answer to two decimal places. Do not round intermediate calculations.

Answer 1

ROE with All equity

Assets= 1000,000 = Equity

OPerating income= 1,000,000*30% = $300,000

Tax= 40% * 300,000 = $120,000

Net Income = 300,000- 120,000 = $180,000

ROE= Net Income/ Equity

= 180,000/ 1000,000

=18%

ROE with 35% Debt

Assets= 1000,000

Debt= 35%*1000,000 = $350,000

Equity= Assets- debt = $650,000

OPerating income= 1,000,000*30% = $300,000

Less: Interest = 8%* 350,000 = $28,000

Profit before tax= 272,000

Tax= 40% * 272,000 = $108,800

Net Income = 272,000- 108800 = $163,200

ROE= Net Income/ Equity

=163200/ 650000

=25.11%