Question

Asked Mar 16, 2019

Jacob Cornwall has a business in which he’s invested $250,000 of his own money. Jacob Cornwall has a business in which he’s invested $250,000 of his own money, which is the firm’s only capital. (There are no other equity investors and no debt.) In a recent year the firm had net income of $20,000 for a return on equity of 8% ($20,000/$250,000). What will the firm’s return on equity be next year if net income from business operations remains the same but it borrows $150,000 returning the same amount to Jake from the equity account if

- The after tax interest rate is 6%.
- The after tax interest rate is 10%.
- Comment on the difference between the results of a and b.

Step 1

Net income from business operations = NOPAT = $ 20,000

Part (1)

Post tax interest rate = 6%

Debt = $ 150,000

Post tax interest expense= 6% x 150,000 = $ 9,000

Hence net income = NOPAT - post tax interest expense = $ 20,000 - 9,000 = $ 11,000

Equity = Initial equity capital - equity capital returned = $ 250,000 - $ 150,000 = $ 100,000

ROE = Net income / Equity capital = 11,000 / 100,000 = 11%

Step 2

Part (2)

Post tax interest rate = 10%

Debt = $ 150,000

Post tax interest expense= 10% x 150,000 = $ 15,000

Hence net income = NOPAT - post tax interest expense = $ 20,000 - 15,000 = $ 5,00...

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