Central City Construction (CCC) needs $1 million of assets to , and it expects t

Question

Central City Construction (CCC) needs $1 million of assets to , and it expects to have a basic earning power ratio of 35%. CCC will own no securities, so all of its income will be operating income. If it chooses to, CCC can finance up to 30% of its assets with debt, which will have an 8% interest rate. Assuming a 30% tax rate on all taxable income, what is the difference between CCC's expected ROE if it financeswith 30% debt versus its expected ROE if it finances entirely with common stock? Round your answer to two decimal places. Do not round intermediate calculations.

Explanation / Answer

EBIT/Assests = 0.35

ROE = Net Profit /Equity ;

EBIT = 0.35*Assests = $0.35 million

For Interest if Debt is 0.3 times = 0.30*0.08 = $0.024 million

(EBIT - INTEREST)*(1-T) = NEt Profit = $0.2282 million

Equity = 0.7 million

ROE = 02282/0.7 = 0.326 ----(in case of 30 % debt)

In case of no debt ;

EBIT = $0.35 million ;

no interest ;

so

Net Profit = 0.35*(1-T) = $0.245 million

Equity = $1 milliom

ROE = 0.245/1 =0.245 ;

Difference = 0.326 -0.245 = 0.081 = 8.1 %

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