a. Nodebt is a company with total assets of $100M and pays corporate taxes at th

Question

a. Nodebt is a company with total assets of $100M and pays corporate taxes at the rate of 30%. Nodebt generates EBITs of $5M, $10M, $15M in a bad year, a normal year, and a good year respectively. Calculate the rate of return on equity of Nodebt in the three scenarios.

b. Somedebt is an identical company except that $50M of its $100M total assets is financed with debt bearing an interest rate of 8%. Calculate the rate of return on equity of Somedebt in the three scenarios of earnings.

c. Which company among the two has riskier equity to be invested in?

Explanation / Answer

Part - A

Since there is no Debt, the rate of return in each of the 3 scenarios will be

Bad : Rate of return is 5/100 =5%

Normal: Rate of return is 10/100 =10% and

Good: Rate of return is 15/100 = 15%

Part - B

In this Situation there is debt component and interest has to be paid on the debt component which reduced the EBIT

Effective interest rate considering 30% tax will be 0.08 *(1-0.3) = 5.6%

Therefore interest payment at 5.6% on 50 Million debt will be 0.056*50 =2.8 Million

Bad: EBIT = 5-2.8 = 2.2 Million and Rate of return is 2.2/50 =4.4%

Normal: EBIT = 10-2.8 =7.2 Million and Rate of return is 7.2/50 = 14.4%

Good: EBIT = 15-2.8 = 12.2 Million and Rate of return is 12.2/50 = 24.4%

Part C

Nodebt is more risky since it is all equity and there is no tax shield for the debt component as in Somedebt

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