Can I have some help with This Problem please. Jacob Cornwall has a business in
ID: 2765302 • Letter: C
Question
Can I have some help with This Problem please. Jacob Cornwall has a business in which he's invested $250,000 of his own money, which is the firms only capital. (There are no other equity investors and no debt.) In a recent year, the firm had net income of $20,000 for a return on equity of 8% ($20,000/$250,000). What will the firm s return on equity he next year if net income from business operations remains the since but it borrows $150,000 returning the same amount to Jake from the equity account if: The after tax interest rate is 6%. The after tax interest rate is 10%. Comment on the difference between the results of a and b.Explanation / Answer
When borrowing is $150,000:
(a) Interest paid = $150,000 x 6% = $9,000
Net income = $(20,000 - 9,000) = $11,000
Equity = $(250,000 - 150,000) = $100,000
(Because $150,000 which was borrowed, was repaid to Jacob from equity account)
ROE = $11,000 / $100,000 = 0.11 or 11%
(b) Interest paid = $150,000 x 10% = $15,000
Net income = $(20,000 - 15,000) = $5,000
Equity = $(250,000 - 150,000) = $100,000
ROE = $5,000 / $100,000 = 0.05 or 5%
(c) The difference is due to the after tax interest rate. In case (a), interest rate is lower, resulting in lower interest expense and higher net income compared to in case (b), so ROE is higher in case (a).
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