Problem 4-16 Return on Equity Central City Construction (CCC) needs $3 million o

Question

Problem 4-16 Return on Equity Central City Construction (CCC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 25%. CCC will own no securities, so all of its income will be operating income. If it chooses to, CCC can finance up to 45% of its assets with debt, which will have an 10% interest rate. Assuming a 35% tax rate on all taxable income, what is the difference between CCC?s expected ROE if it finances with 45% debt versus its expected ROE if it finances entirely with common stock? Round your answer to two decimal places.

Explanation / Answer

Answer:

In $ Total Asset 3000000 Basic earning power ratio 25% So Earning before interest and tax 750000 Option 1 Option 2 Debt 45% 0 Equity 55% 100% Rate of Interest 10% Tax rate 35% Debt Amount 1350000 0 Equity Amount 1650000 3000000 EBIT 750000 750000 Interest(Debt*interest rate) 135000 0 EBT 615000 750000 Tax 215250 262500 Net Income 399750 487500 ROE= Net Income/Equity 24.23% 16.25% Difference in ROE between Option 1 & 2 = 24.23% - 16.25% 7.98%

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