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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

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 20%. CCC will own no securities, so all of its income will be operating income. If it so chooses, CCC can finance up to 50% 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 40% tax rate on all taxable income, what is the difference between CCC’s expected ROE if it finances these assets with 50% debt versus its expected ROE if it finances these assets entirely with common stock?

Summary Introduction

To identify: The difference in return on equity with 50% debt and entirely financed with common stock.

Return on equity: Return on equity is the return from the equity. It is the ratio of net income and shareholders’ equity. This ratio measures the performance of the company and tells how well the company is performing. This ratio is used to compare own firm with competitors.

Explanation

Solution:

Given,

Return on equity with debt is 19.2%.

Return on equity without debt is 12%.

Formula to calculate difference in return on equity with 50% debt and fully financed from equity is,

Difference=Return on Equity with DebtReturn on Equity without Debt

Substitute 19.2% for return on equity with debt and 12% for return on equity without debt.

Difference=19.2%12%=7.2%

Thus, difference is 7.2%.

Working notes:

Calculate Earnings before interest and tax.

Given,

Total asset is 1,000,000.

Basic earnings power ratio is 20%.

The formula to calculate EBIT of the company is,

EBIT=Total Assets×Basic Earnings Power

Substitute $1,000,000 for total assets and 20% for basic earnings power in above formula.

EBIT=$1,000,000×20%=$200,000

Thus, EBIT of the company is $200,000.

Calculate return on equity if the company has zero debt.

Given,

EBIT of the company is $200,000.

Tax rate is 40%.

Total asset is $1,000,000.

Weight of equity is 100%.

The formula to calculate return on equity is,

Return on Equity=EBIT(1Tax Rate)Total Assets×Weight of Equity

Substitute $200,000 for EBIT, 40% for tax rate, $1,000,000 for total assets and 100% for weight of equity.

Return on Equity=$200,000(140%)$1,000,000×100%=$120,000$1,000,000=12%

Thus, return on equity is 12%

Calculate annual interest expense if the company’s capital consists 50% debt

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