Question

No-Toxic-Toys currently has $400,000 of equity and is planning an $160,000 expansion to meet increasing demand for its product. The company currently earns $100,000 in net income, and the expansion will yield $50,000 in additional income before any interest expense. The company has three options: (1) do not expand, (2) expand and issue $160,000 in debt that requires payments of 8% annual interest, or (3) expand and raise $160,000 from equity financing. For each option, compute (a) net income and (b) return on equity (Net Income ÷ Equity). Ignore any income tax effects. (Round "Return on equity" to 1 decimal place.)

Answer 1

OPTION 1:

net income = $100,000

return on equity = $100,000 / $400,000 = 25%

OPTION 2:

net income = $100,000 + $50,000 - ($160,000 x 8%) = $150,000 - $12,800 = $137,200

return on equity = $137,200 / $400,000 = 34.3% (yields highest returns but also increases risk)

OPTION 3:

net income = $100,000 + $50,000 = $150,000

return on equity = $150,000 / ($400,000 + $160,000) = $150,000 / $560,000 = 26.79%