Problem 4-1.6 Return on Equity Central City Construction (CCC) needs $3 million

Question

Problem 4-1.6 Return on Equity Central City Construction (CCC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 30%. CCC will own no securities, so all of its income will be operating income. If it chooses to, CCC can finance up to 35% of its assets with debt, which will have an 8% interest rate. Assuming a 40% tax rate on all taxable income, what is the difference between CCCs expected ROE if it finances with 35% debt versus its expected ROE if it finances entirely with common stock? Round your answer to two decimal places.

Explanation / Answer

Basic Earning Power = EBIT / Assets

Or, 0.30 = EBIT / $3 million

EBIT = $3 million x 0.30 = $900,00

Net Income = EBIT x (1 - tax rate) = $900,000 x (1 - 0.4)

= $540,000

Asuming zero liabilities, stockholder equity = assets

Or, equity = $3 million

So, ROE (In absence of debt) = Net Income / Equity = $540,000 / $3 million = 18%

Alternatively, CCC wants to finance 35% of assets with debt.

Amount of debt = $3 million x 0.35 = $1,050,000

Equity = $3 million x 0.65 = $ 1,950,000

After-tax Interest on debt = $1,050,000 x 8% x (1 - 0.40) = $50,400

So, with debt financing, Net Income = $(540,000 - 50,400) = $489,600

ROE = $489,600 / $1,950,000 = 25.11%

So, difference in ROE = (25.11 - 18)% = 7.11%

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