You have been hired by a new firm that is just being started. The CFO wants to f

Question

You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Other things held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROENew ROEOld? Operating Data Other Data Capital $4,000 Higher wd 60% ROIC = EBIT(1 T)/Capital 13.00% Higher interest rate 13% Tax rate 35% Lower wd 10% Lower interest rate 9%

Explanation / Answer

Step 1: Calculate Net Income Under Both the Capital Structures

To calculate net income, we first need to determine the EBIT. The EBIT can be calculated with the use of formula for ROIC provided in the question as follows:

ROIC = EBIT*(1-Tax Rate)/Capital

Substituting the values provided in the question, we get,

13% = EBIT*(1-35%)/4,000

Rearranging values, we get,

EBIT = (4,000*13%)/65% = $800

________

The net income with 60% debt and 10% debt is calculated with the use of following table:

_______

Step 2: Calculate Return on Equity (New, Old and Change)

The formula for calculating ROE is given below:

ROE = Net Income (New or Old)/Equity (New Or Old)*100

where

Old Equity = Capital*(1-Old Debt Ratio) = 4,000*(1-10%) = $3,600

New Equity = Capital*(1-New Debt Ratio) = 4,000*(1-60%) = $1,600

Using the values calculated above, we get,

ROE (Old) = 496.6/3,600*100 = 13.7944%

ROE (New) = 317.2/1,600*100 = 19.8250%

ROE Change = 19.8250% - 13.7944% = 6.03% (answer)

60.00% Debt 10.00% Debt EBIT 800 800 Less Interest 312 (4,000*60%*13%) 36 (4,000*10%*9%) EBT 488 764 Less Taxes (35%) 170.8 267.4 Net Income $317.2 $496.6

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