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? Do not round your intermediate calculations. Operating Data Other Data Capital $4,000 Higher wd 60% ROIC = EBIT(1 – T)/Capital 17.00% Higher interest rate 13% Tax rate 35% Lower wd 10% Lower interest rate 9%

Explanation / Answer

D/E ratio Wd Int rate Tax Rate Debt Equity Interest 60% CFO Debt equity 60%/40%            1.50 13% 35% 2400 1600 312 10% CEO Debt equity 10%/90%            0.11 9% 35% 400 3600 36 Capital 4000 ROIC=EBIT(1-T)/Capital=17% EBIT(1-.35)/4000=17% .65*EBIT=680 EBIT=1046 60% Debt 10% Debt EBIT    1,046.00    1,046.00 Interest       312.00          36.00 EBT       734.00    1,010.00 Tax       256.90       353.50 Available to equity holders       477.10       656.50 Stock    1,600.00    3,600.00 Rate 29.82% 18.24% 11.58%

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