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 $140,000 in net income, and the expansion will yield $70,000 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 9% 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

Down below

Explanation:

1. It does not expand

a. Net income= $100,000 (as given in the question)

b. Return on equity= (net income)/(shareholder’s equity)

Shareholder’s equity= $400,000

Thus return on equity= 100000/400000 = 0.25 or 25%

2. It expands and issue $160,000 in debt

a. Net income= $100000 + 50000 – 12800 (debt interest 8% of $160000)

= $137,200

b. Return on equity= (net income)/(shareholder’s equity)

= 137200/400000

=0.343 or 34.3%

3. It expands and raises equity of $160000

a. Net Income= $100000 + 50000

= $150000

b. Return on equity= (net income)/(shareholder’s equity)

= 150000/(400000 + 160000)

Where ($560,000) 400000 + 160000 is shareholder’s equity

= 0.27 or 27%