Suppose that you are the sole owner of an all-equity firm, the assets of which a

Question

Suppose that you are the sole owner of an all-equity firm, the assets of which are worth $500,000. The ROA is 15% per year paid as a dividend to you. If you have the firm issue $100,000 of debt at 6%, the interest expense will be paid by the firm out of the earnings that had constituted ROA. The debt is secured by the firm, not by you. The firm pays a special dividend to you of $100,000 on the day the debt is issued. The tax rate is 34%. What will your return on equity be in the year after you go into debt?

Explanation / Answer

Answer;

Current ROA = 15 % on assets

Hence current earnings = 15% * 500000 = $75000

After issuing S100000 debt the total capital shall be = $500000+$100000 = $600000

And the ROA Shall be = 600000*15% = $90000

Interest on debt shall be = $100000 *6% = $6000

Hence net earning before tax shall be = 90000-6000 = $84000

Less tax = 84000*34% = 28560

Earnings after tax = 84000

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