Fill in the table using the following information Assets required for operation:
ID: 2630305 • Letter: F
Question
Fill in the table using the following information
Assets required for operation: $2,000
Case A: firm uses only equity financing
Case B: firm uses 30% debt with a 10% interest rate and 70% equity
CaseC: firm uses 50% debt with a 12% interest rate and 50% equity
A B C
Debt Outstanding $ $ $
Stockholders' Equity
Earnings before interest & taxs 300 300 300
Interest Expense
Earnings before taxes
Taxes (40% of earnings)
Net earnings
Return on stockholders equity % % %
What happens to the rate of return on the stockholders' investment as the amount of debt increases? Why did the rate of interest increase in Case C?
I hope someone can help. Please show all work and explain in detail. Thank you:-)
Explanation / Answer
A
B
As the proportion of debt increases, the risk of the firm increases, requiring an increase in return on stockholder's equity.
In the third case, the interest rate increases, as the firm is highly geared, required even the debt holders high return.
A B C Debt Outstanding 0 600 1000 Stockholder's Equity [i] 2000 1400 1000 EBIT 300 300 300 Interest Expense 0 60 120 EBT 300 240 180 Tax @ 40% 120 96 72 Net Earnings [ii] 180 144 108 Return on Equity [ii/i] 9.00% 10.29% 10.80%Related Questions
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