Firms HD and LD are identical except for their use of debt and the interest rate
ID: 2726640 • Letter: F
Question
Firms HD and LD are identical except for their use of debt and the interest rates they pay HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD ROELD? Please show a detail answer, step-by step.
Applicable to Both Firms Firm HD's Data Firm LD's Data
Capital
$3,000,000
wd
70%
wd
20%
EBIT
$500,000
Int. rate
12%
Int. rate
10%
Tax rate
35%
Capital
$3,000,000
wd
70%
wd
20%
EBIT
$500,000
Int. rate
12%
Int. rate
10%
Tax rate
35%
Explanation / Answer
SOLUTION :
HD
LD
EBIT
500000
500000
LESS : INTEREST (DEBT*INTEREST RATE)
252000
60000
EBT
248000
440000
LESS : TAX @ 35%
86800
154000
EAT
161200
286000
EQUITY CAPITAL
900000
2400000
ROE (EAT/EQUITY CAPITAL)
17.91%
11.92%
HD
LD
TOTAL CAPITAL
3000000
3000000
LESS : DEBT
2100000
600000
EQUITY CAPITAL
900000
2400000
HD
LD
EBIT
500000
500000
LESS : INTEREST (DEBT*INTEREST RATE)
252000
60000
EBT
248000
440000
LESS : TAX @ 35%
86800
154000
EAT
161200
286000
EQUITY CAPITAL
900000
2400000
ROE (EAT/EQUITY CAPITAL)
17.91%
11.92%
HD
LD
TOTAL CAPITAL
3000000
3000000
LESS : DEBT
2100000
600000
EQUITY CAPITAL
900000
2400000
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