You were hired as the CFO of a new company that was founded by three professors

Question

You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL - ROEU? 0% Debt, U 60% Debt, L Expected unit sales (Q) 32,000 32,000 Price per phone (P) $250.00 $250.00 Fixed costs (F) $1,000,000 $1,000,000 Variable cost/unit (V) $200.00 $200.00 Required investment $2,500,000 $2,500,000 % Debt 0.00% 60.00% Debt, $ $0 $1,500,000 Equity, $ $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 35.00% 35.00%

a. 16.52% b. 15.70% c. 12.56% d. 11.33% e. 13.65%

You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be S250.o0 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL-ROEU? 090 Debt, U Expected unit sales (Q Price per phone (P) Fixed costs (F) Variable cost/unit (V) Required investment % Debt Debt, $ Equity, $ Interest rate Tax rate 6090 Debt, L 32,000 $250.00 $1,000,000 $200.00 $2,500,000 60.00% $1,500,000 $1,000,000 10.00% 35.00% 32,000 $250.00 $1,000,000 $200.00 $2,500,000 3 $2,500,000 9 35.00% a. 16.52% b. 15.70% c. 12.56% d, 11.33% e. 13.65% O

Explanation / Answer

Ans. E 13.65% 0% Debt, U 60% Debt, L Sales Revenues 8000000 8000000 (32000 * 250) Less: Variable costs -6400000 -6400000 (32000 * 200) Less: Fixed costs -1000000 -1000000 Operating income 600000 600000 Less: Interest -150000 (1500000 * 10%) Taxable income 600000 450000 Less: Taxes -210000 -157500 (35% of Taxable income) Net Income $390,000 292500 ROE 29.25% 15.60% *Calculation: ROE: Net income / Equity * 100 60% Debt, L 292500 / 1000000 * 100 29.25 0% Debt, U 390000 / 2500000 * 100 15.6 Difference ( ROEl - ROEu) 13.65

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