Debt versus Equity Financing You are considering a stock investment in one of tw

Question

Debt versus Equity Financing You are considering a stock investment in one of two firms (AllDebt, Inc. and AllEquity, Inc.), both of which operate in the same industry and have identical operating income of $600,000. AllDebt, Inc. finances its $1.2 million in assets with $1 million in debt (on which it pays 10 percent interest annually) and $.2 million in equity. AllEquity, Inc. finances its $1.2 million in assets with no debt and $1.2 million in equity. Both firms pay a tax rate of 30 percent on their taxable income. What are the asset funders' (the debt holders and stockholders') resulting return on assets for the two firms?

Explanation / Answer

Hi,

Please find the answer as follows:

All Debt

Income = 600000

Less Interest = 100000

Taxable Income = 500000

Less Taxes = 150000

Net Income = 350000

Income Available to Asset Funders = 600000 - 150000 = 450000 (Operating Income - Taxes)

Return on Asset Funders Investment = 450000/1200000*100 = 37.5%

All Equity

Income = 600000

Less Interest = 0

Taxable Income = 600000

Less Taxes = 180000

Net Income = 420000

Income Available to Asset Funders = 600000 - 180000 = 420000 (Operating Income - Taxes)

Return on Asset Funders Investment = 420000/1200000*100 = 35%

Answer is 37.5% and 35%.

Thanks.

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