Problem 2-20 Debt versus Equity Financing (LG2-1) You are considering a stock in
ID: 2767518 • Letter: P
Question
Problem 2-20 Debt versus Equity Financing (LG2-1)
You are considering a stock investment in one of two firms (AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have identical operating income of $7.00 million. AllDebt, Inc., finances its $35 million in assets with $34 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. AllEquity, Inc., finances its $35 million in assets with no debt and $35 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.
Calculate the income available to pay the asset funders (the debt holders and stockholders) and resulting return on asset-funders' investment for the two firms. (Enter your dollar answers in millions of dollars. Round all answers to 2 decimal places.)
You are considering a stock investment in one of two firms (AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have identical operating income of $7.00 million. AllDebt, Inc., finances its $35 million in assets with $34 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. AllEquity, Inc., finances its $35 million in assets with no debt and $35 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.
Explanation / Answer
All Amounts in millions of $ AllDebt AllEquity Income available for asset funders 2.52 4.9 Return on asset-funders' investment 252% 14% Income available for asset funders in All Debt Co will be ($ 7 million - $ 34 million X 10%) X 70% Income available for asset funders in All Equity Co will be $ 7 million X 70% Return on asset-funders investments For All Debt Co. = $ 2.52 million / $ 1 million (Equity Cost) For All Equity Co. = $ 4.9 million / $ 49 million
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