Aaron Levie is the co-founder of Box . Assume that his company currently has $25

Question

Aaron Levie is the co-founder of Box. Assume that his company currently has $250,000 in equity, and he is considering a $100,000 expansion to meet increased demand. The $100,000 expansion would yield $16,000 in additional annual income before interest expense. Assume that the business currently earns $40,000 annual income before interest expense of $10,000, yielding a return on equity of 12% ($30,000/$250,000). To fund the expansion, he is considering the issuance of a 10-year, $100,000 note with annual interest payments (the principal due at the end of 10 years).

Required

Using return on equity as the decision criterion, show computations to support or reject the expansion if interest on the $100,000 note is (a) 10%, (b) 15%, (c) 16%, (d) 17%, and (e) 20%.

What general rule do the results in part 1 illustrate?

Explanation / Answer

STATEMENT SHOWING RETEURN ON EQUITY 10% 15% 16% 17% 20% Net income-Agregate 56000 56000 56000 56000 56000 Less: Interest expense-Aggregate 20000 25000 26000 27000 30000 Net Income for equity 36000 31000 30000 29000 26000 Equity 250,000 250000 250000 250000 250000 Return on equity 14.40% 12.40% 12% 11.60% 10.40% General Rule: When the cost of additional investmenet is equal to or more than the return it yield, the investment shall be rejected: Here, the results is as follows: Investment amount 100,000 Return on investment 16,000 Return on investment 16% When the cost of investment is lesser than 16%, it is acceptable (i.e. Acceptable at 10% and 15%) When the cost of investment is equal to or higher than 16%, it shall be rejected( i.e. reject at 16%, 17% and 20%)

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