Commonwealth Construction (CC) needs $1 million of assets to get started, and it
ID: 2813186 • Letter: C
Question
Commonwealth Construction (CC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 15%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 60% of its assets with debt, which will have an 11% interest rate. If it chooses to use debt, the firm will finance using only debt and common equity, so no preferred stock will be used. Assuming a 30% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 60% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.
Explanation / Answer
BEP (Basic Earning Power) ratio = 15%
BEP (Basic Earning Power) ratio = EBIT/ Total Assets
Total Assets = 1,000,000
BEP = 15%
15% = EBIT/ 1,000,000
EBIT = 150,000
Taxes = 30%
Net Income = 150,000 * (1 - 0.30)
Net Income = 105,000
ROE = Net Income/ Total Equity
As total debt is 0, so total assets will be equal to total equity
ROE = 105,000/ 1,000,000
ROE = 10.50%
Part B:
Debt = 60% of assets
Debt = 600,000
Equity = 40% of Assets
Equity = 400,000
EBIT = 150,000
Interest = 11% * Debt
Interest = 11% * 600,000
Interest = 66,000
EBT = 150,000 - 66,000
EBT = 84,000
Net Income = EBT * (1 - Tax Rate)
Net Income = 84,000 * (1 - 30%)
Net Income = 58,800
ROE = Net Income/ Equity
ROE = 58,800/ 400,000
ROE = 14.70%
Difference between ROE = 14.70% - 10.50%
Difference between ROE = 4.20%
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