Return on Equity Central City Construction (CCC) needs $1 million of assets to g

Question

Return on Equity

Central City Construction (CCC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 30%. CCC will own no securities, so all of its income will be operating income. If it chooses to, CCC can finance up to 55% of its assets with debt, which will have an 12% interest rate. Assuming a 30% tax rate on all taxable income, what is the difference between CCC's expected ROE if it financeswith 55% debt versus its expected ROE if it finances entirely with common stock? Round your answer to two decimal places.

Explanation / Answer

BEP Ratio = Earnings Before interest and tax ÷ Total assets So Earnings Before interest and tax (EBIT) = Total Assets * BEP Ratio = $1M*30% = $0.3M Tax Rate T = 30%. As tthere is no Debt, Int = 0 So EBT = EBIT - Int = $0.3M-0 = $0.3M So Net Income = (1-T)*EBT = 0.7*0.3 = $0.21M Thus if there is no debt, Net Income is $0.21M ROE is expressed as a percentage and calculated as: Return on Equity(ROE) = Net Income/Shareholder's Equity = $0.21M/$1M = 21% So ROE = 21% when no debt .......(a) WIth 55% debt, Stock = $0.45M & Debt = $0.55M SO Int on Debt @12% = 12%*0.55M = $0.066M EBIT = $0.3M EBT = EBIT - Int on Debt = $0.3M - $0.066M = $0.234M Net Income = (1-T)*EBT = 0.234*.7 = $0.1638M ROE is expressed as a percentage and calculated as: Return on Equity (ROE) = Net Income/Shareholder's Equity ie ROE = 0.1638M/0.45M = 0.364 = 36.4% .........(b) So Dif between ROE when there is 50% debt & no debt is 36.4% - 21% = 15.4%

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