Return on Equity Central City Construction (CCC) needs $2 million of assets to g

Question

Return on Equity Central City Construction (CCC) needs $2 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 30% tax rate on all taxable income, what is the difference between CCC's expected ROE if it financeswith 45% debt versus its expected ROE if it finances entirely with common stock? Round your answer to two decimal places.

Explanation / Answer

100%Equity ---------------------------- EBIT: $200,000 Interest: $0 Taxes: ($80,000) EAT: $120,000 Equity: $1,000,000 ROE12.0% 50% Debt -------------- EBIT: $200,000 Interest: ($40,000) Taxes: ($64,000) EAT: $96,000 Equity: $500,000 ROE: 19.2% This is my thought and is contingent on interest expense being tax deductible to the corporation. Under the equity scenario. Taxes are $80,000 or 40% of $200,000 which is 20% of the $1mm asset base. So the $120,000 earnings after tax divided by the $1mm base is 12% With 50% leverage, you deduct $40,000 (8% of $500,000 financing) and taxes on remaining amount. The new equity base is smaller at $500,000 so the ROE is higher at 19.2%.

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