Question

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 $23.5 million. NoEquity, Inc. finances its $70 million in assets with $69 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc. finances its $70 million in assets with no debt and $70 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.

Required:
Calculate the net income and return on assets for the two firms.

Answer 1

Investment in NoEquity, Inc. and NoDebt, Inc.

NoEquity, Inc. NoDebt, Inc.

Net Income $11.62 million $16.45 million

Return on assets 16.6% 23.5%

Step-by-step explanation:

a) Data and Calculations:

NoEquity, Inc. NoDebt, Inc.

Investments:

Debt $69 million $0

Equity $1 million $70 million

Assets $70 million $70 million

Operating income $23.5 million $23.5 million

Interest (10%) 6.9 million 0

Income before tax $16.6 million $23.5 million

Tax expense (30%) 4.98 million 7.05 million

Net Income $11.62 million $16.45 million

Return on assets $11.62/$70 $16.45/$70

= 0.166 0.235

= 16.6% 23.5%