Firm AB and Firm YZ are identical except for their debt-to-total-assets ratios (
ID: 2646507 • Letter: F
Question
Firm AB and Firm YZ are identical except for their debt-to-total-assets ratios (D/TAs) and interest rates on debt. Each has $200,000 in assets, $40,000 EBIT, and a 40 percent marginal tax rate. Firm AB has a D/TA ratio of 40 percent and pays 7.5 percent interest on its debt, whereas YZ has a 60 percent interet on its debt and pays 10 percent interest on debt. Each firm has 5,000 shares of common stock outstanding. Calculate each firm's EPS and ROE (ROE = Net income/Equity). Discuss your results.
Explanation / Answer
Firm AB
EBIT = 40000
Asset = 200000
D/TA ratio = 40%
Interest rate on its debt = 7.5%
common stock outstanding = 5000 share
Debt = 40%*200000 = 80000
Equity = 200000 - 80000 = 120000
interest on its debt = 7.5%*80000 = 6000
Net Income =( EBIT - interest on its debt )*(1-tax rate)
Net Income = (40000 - 6000)*(1-40%)
Net Income = $ 20400
EPS = 20400/5000
EPS = 4.08
ROE = 20400/120000
ROE = 17%
Firm YZ
EBIT = 40000
Asset = 200000
D/TA ratio = 60%
Interest rate on its debt = 10%
common stock outstanding = 5000 share
Debt = 60%*200000 = 120000
Equity = 200000 - 120000 = 80000
interest on its debt =10%*120000 = 12000
Net Income =( EBIT - interest on its debt )*(1-tax rate)
Net Income = (40000 - 12000)*(1-40%)
Net Income = $ 16800
EPS = 16800/5000
EPS = 3.36
ROE = 16800/80000
ROE = 21%
As firms AB has higher EPS than Firm YZ where as Firm YZ has higher ROE than Firm AB , its provides that Firm YZ has given higher Return to its equity where as it having lower price in compaision to Firm AB
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