Question

Commonwealth Construction (CC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CC will own no securities, so all of its income will be operating income. If it so chooses, CC can finance up to 30% 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 35% tax rate on all taxable income, what is the difference between CC's expected ROE if it finances these assets with 30% debt versus its expected ROE if it finances these assets entirely with common stock?

Answer 1

100%Equity
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EBIT: $200,000
Interest: $0
Taxes: ($80,000)
EAT: $120,000
Equity: $1,000,000
ROE12.0%

50% Debt
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EBIT: $200,000
Interest: ($40,000)
Taxes: ($64,000)
EAT: $96,000
Equity: $500,000
ROE: 19.2%

This is my thought and is contingent on interest expense being tax deductible to the corporation.

Under the equity scenario. Taxes are $80,000 or 40% of $200,000 which is 20% of the $1mm asset base. So the $120,000 earnings after tax divided by the $1mm base is 12%

With 50% leverage, you deduct $40,000 (8% of $500,000 financing) and taxes on remaining amount. The new equity base is smaller at $500,000 so the ROE is higher at 19.2%.