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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

RETURN ON EQUITY Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 35%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 30% 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 CC’s expected ROE if it finances these assets with 30% 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 30% 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

Given,

Return on equity with debt is 27.9% (working note).

Return on equity without debt is 21% (working note).

The formula to calculate the 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 27.9% for return on equity with debt and 21% for return on equity without debt.

Difference=27.9%21%=6.9%

Thus, the difference is 6.9%.

Working notes:

Calculate Earnings before interest and tax.

Given,

Total asset is 3,000,000.

Basic earnings power ratio is 35%.

The formula to calculate EBIT of the company is,

EBIT=Total Assets×Basic Earnings Power

Substitute $3,000,000 for total assets and 35% for basic earnings power in above formula.

EBIT=$3,000,000×35%=$1,050,000

Thus, EBIT of the company is $1,050,000.

Calculate return on equity if the company has zero debt.

Given,

EBIT of the company is $1,050,000.

The tax rate is 40%.

Total asset is $3,000,000.

The 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 $1,050,000 for EBIT, 40% for tax rate, $3,000,000 for total assets and 100% for weight of equity.

Return on Equity=$1,050,000(140%)$3,000,000×100%=$630,000$3,000,000=21%

Thus, return on equity is 21%

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

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