You are considering a stock investment in one of two firms (NoEquity, Inc., and
ID: 2732384 • Letter: Y
Question
You are considering a stock investment in one of two firms (NoEquity, Inc., and NoDebt, Inc.), both of which operate in the same industry and have identical operating income of $22.5 million. NoEquity, Inc., finances its $80 million in assets with $79 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $80 million in assets with no debt and $80 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.
Calculate the net income and return on assets for the two firms. (Enter your dollar answers in millions of dollars. Round all answers to 2 decimal places.)
Explanation / Answer
No Debt Inc
Operating income(EBIT) = $22.5 mn
As there is no debt thus no interest is required to be paid by the company
Thus EBT = $22.5 mn
less : tax @30% = 22.5 - [ 30% of 22.5 ] = $15.75 mn
Thus, Profit after tax or Net Income = $15.75 mn
and Return on asset = Net Income / Total assets
= 15.75 / 80 = 0.196875 or 19.7 %
No Equity Inc
Operating Income(EBIT) = $22.5 mn
As the company has financed its assets using debt thus it is to required to pay interest given @10% annually on $79 mn
Therefore, interest = $79 mn * 10% = $7.9 mn
EBT = $22.5 mn - $7.9 mn = $14.6 mn
Less: tax @ 30% = $14.6 mn - [ 30% of 14.6 mn ] = 14.6 - 4.38 = $10.22 mn
Therefore, Profit after tax or Net Income = $10.22 mn
Return on assets = 10.22 / 80 = 0.12775 or 12.78%
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