You work for the CEO of a new company that plans to manufacture and sell a new p

Question

You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $510,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU? Do not round your intermediate calculations.

0% Debt, U 60% Debt, L Oper. income (EBIT) $510,000 $510,000 Required investment $2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common equity $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 35% 35%

Explanation / Answer

For ROEU

EBIT=510,000

EBT(earnings before tax)=EBIT-I =510000-0=510000

profit after tax(PAT)=EBT(1-0.35)=510000*(0.65)=331500

ROEU=PAT/common equity=331500/2,500,000=0.1326~13.26%

for ROEU

EBIT=510000

Earnings Before Tax(EBT)=EBIT-I=510000-150000=360000

Profit After Tax=EBT(1-tax)=360000(1-0.35)=234000

ROEL=Profit After Tax/common equity=234000/1000000=0.234~23.4%

ROEL-ROEU=23.4-13.26=10.14%

hence, b is correct option.

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