Firms A and B aare identical except for for theirlevel of debt and the interst r
ID: 2661788 • Letter: F
Question
Firms A and B aare identical except for for theirlevel of debt and the interst rates they pay on debr. Each has $2million in assets, $400,000 of EBIT, and 40% tax rate. However,firm A has a debt-toassets ration of 50% and pays 12% interst onits debts, while firm B has a 30% debt ratio and pays only 10%interest onits debts. What is the difference between the two firmsROEs? Firms A and B aare identical except for for theirlevel of debt and the interst rates they pay on debr. Each has $2million in assets, $400,000 of EBIT, and 40% tax rate. However,firm A has a debt-toassets ration of 50% and pays 12% interst onits debts, while firm B has a 30% debt ratio and pays only 10%interest onits debts. What is the difference between the two firmsROEs?Explanation / Answer
Firm "A"
Firm "B"
$2,000,000
$2,000,000
$400,000
$400,000
40%
40%
50%
30%
12%
10%
$2,000,000 * 0.50
$2,000,000 * 0.30
$1,000,000
$600,000
$400,000.00
$400,000.00
($120,000.00)
($60,000.00)
$280,000.00
$340,000.00
($112,000.00)
($136,000.00)
$168,000.00
$204,000.00
$2,000,000 - $1,000,000
$2,000,000 - $600,000
$1,000,000
$$1,400,000
$168,000 / $1,000,000
$204,000 / $1,400,000
0.168
0.1457
16.80%
14.57%
Firm "A"
Firm "B"
Total Assets$2,000,000
$2,000,000
EBIT$400,000
$400,000
Income Tax40%
40%
Debt Ratio50%
30%
Interest rate on Debt12%
10%
Calculating TotalDebt: Debt Ratio = Total Debt/ Total Assets Total Debt = Debt Ratio * Total Assets$2,000,000 * 0.50
$2,000,000 * 0.30
Total Debt$1,000,000
$600,000
Calculating Net Income: EBIT$400,000.00
$400,000.00
Less: Interest on Debt($120,000.00)
($60,000.00)
EBT$280,000.00
$340,000.00
Less: Income Tax($112,000.00)
($136,000.00)
Net Income$168,000.00
$204,000.00
ROE = Net Income / TotalEquity Total Equity = Total Assets - Total Debt$2,000,000 - $1,000,000
$2,000,000 - $600,000
Total Equity$1,000,000
$$1,400,000
Return on Equity$168,000 / $1,000,000
$204,000 / $1,400,000
Return on Equity0.168
0.1457
ROE16.80%
14.57%
Difference between ROE (16.80%- 14.57%) = 2.23%Related Questions
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