Problem 2-19 Debt versus Equity Financing (LG2-1) You are considering a stock in

Question

Problem 2-19 Debt versus Equity Financing (LG2-1)

You are considering a stock investment in one of two firms (NoEquity, Inc., and NoDebt, Inc.), both of which operate in the same industry and have identical operating income of $19.5 million. NoEquity, Inc., finances its $60 million in assets with $59 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $60 million in assets with no debt and $60 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.

Calculate the net income and return on assets 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 (NoEquity, Inc., and NoDebt, Inc.), both of which operate in the same industry and have identical operating income of $19.5 million. NoEquity, Inc., finances its $60 million in assets with $59 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $60 million in assets with no debt and $60 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.

Explanation / Answer

No Equity No Debt Operating income 19.5 19.5 Less Interest 5.9 0 Profit before tax 13.6 19.5 Less Tax 4.08 5.85 Net Income 9.52 13.65 Total asset 60 60 ROA= Net income/Total asset ROA= 9.52/60 13.65/60 ROA= 15.87% 22.75% Interest= 10% of 59 Interest= 5.9

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