You were hired as the CFO of a new company that was founded by three professors

Question

You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL - ROEU?

0% Debt, U 60% Debt, L Expected unit sales (Q) 32,000 32,000 Price per phone (P) $250.00 $250.00 Fixed costs (F) $1,000,000 $1,000,000 Variable cost/unit (V) $200.00 $200.00 Required investment $2,500,000 $2,500,000 % Debt 0.00% 60.00% Debt, $ $0 $1,500,000 Equity, $ $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 35.00% 35.00%

Explanation / Answer

ROE = Net Income / Equity

ROEU = 15.60%, ROEL = 29.25%

=> Difference = 13.65%

Hence, d is correct.

0% Debt, U 60% Debt, L Sales $8,000,000 $8,000,000 VC -$6,400,000 -$6,400,000 FC -$1,000,000 -$1,000,000 EBIT $600,000 $600,000 Interest $0 -$150,000 EBT $600,000 $450,000 Tax (35%) -$210,000 -$157,500 Net Income $390,000 $292,500 Equity $2,500,000 $1,000,000 ROE 0.156 0.2925 Difference 0.1365

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