Suppose a company is considering expanding its production plants. The expansion
ID: 2784876 • Letter: S
Question
Suppose a company is considering expanding its production plants. The expansion can increase the net income before interest and tax by $30 million and requires a financing of $200 million. The two proposed ways of financing are as follows: a. By issuing common stock b. By issuing common stock and 8% bonds in the ratio of 1:1. Calculate the following income statement (income tax 30%): fILL YOUR RESULTS IN THE TABLE ternative 00,000.000 Common stock 100,000.000 bonds ernative 200,000,000 Common stock EBIT Interest Expense EBT Taxes Net Income 10 According to the previous project's income statement, ROA is: A) Alternative 1: 10.50%; Alternative 2: 7.70% B) Alternative 1: 11.50%; Alternative 2: 15.00% C) Alternative 1: 15.00%; Alternative 2: 6.70% D) Alternative 1: 10.50%; Alternative 2: 15.40% 1 According to the previous project's income statement, ROE is: A) Alternative 1: 10.50%; Alternative 2: 15.40% B) Alternative 1: 10.50%; Alternative 2: 7.70% C) Alternative 1: 15.00%; Alternative 2: 6.70% D) Alternative 1: 10.50%; Alternative 2: 11.00%Explanation / Answer
Alternative 1:
EBIT = 30 million
Interest Expense = 0
EBT = 30 million
Taxes = 0.3*30 = 9 million
Net Income = 30-9 = 21 million
Alternative 2:
EBIT = 30 million
Interest Expense = 0.08*200/2 = 8 million
EBT = 30-8 = 22 million
Taxes = 0.3*22 = 6.6 million
Net Income = 22-6.6 = 15.4 million
10. ROA:
Alternative 1: Net income/net assets = 21/20 = 10.5%
Alternative 2: Net income/net assets = 15.4/20 = 7.7%
11. ROE:
Alternative 1: Net income/net Equity = 21/20 = 10.5%
Alternative 2: net income/net Equity = 15.4/10 = 15.4%
12. Option C, both the statements are correct since alternative 1 doesn't have debt and hence no leverage. While alternative 2 have highest return on Equity as per the 11th question.
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