question archive Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 25%
Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 25%
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Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 25%. 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 10% 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 40% 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 place
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Given the following:
Assets required = $3,000,000
Basic earning power ratio = 25%
Tax rate = 40%
Interest rate = 10%
Basic earning power ratio = EBIT/Total Assets
25% = EBIT/$3,000,000
EBIT = $3,000,000 × 25% = $750,000
If finances the assets with 60% debt,
Asset financed by debt = $3,000,000 × 60% = $1,800,000
Assets financed by equity = $3,000,000 × 40% = $1,200,000
Return on equity (ROE) = Net Income/Equity
ROE if financed by 60% debt = $342,000/$1,200,000 = 28.50%
ROE if financed by 100% equity = $450,000/$3,000,000 = 15%
Difference in ROE = 28.50% - 15% = 13.50%
Difference between the expected ROE if financed by 60% debt and if financed by 100% equity is 13.50%
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