You are considering a stock investment in one of two firms (NoEquity, Inc., and

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 $19.5 million. NoEquity, Inc., finances its $60 million in assets with $59 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $60 million in assets with no debt and $60 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.)

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 $19.5 million. NoEquity, Inc., finances its $60 million in assets with $59 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $60 million in assets with no debt and $60 million in equity. Both firms pay a tax rate of 30 percent on their taxable income.

Explanation / Answer

NoEquity, Inc.:

Operating Income = $19.50 million
Total Assets = $60.00 million
Value of Debt = $59.00 million
Value of Equity = $1.00 million
Interest Rate = 10%

Interest Expense = 10% * $59.00 million
Interest Expense = $5.90 million

Net Income = (Operating Income - Interest Expense) * (1 - tax)
Net Income = ($19.50 million - $5.90 million) * (1 - 0.30)
Net Income = $13.60 million * 0.70
Net Income = $9.52 million

Return on Assets = Net Income / Total Assets
Return on Assets = $9.52 million / $60.00 million
Return on Assets = 15.87%

NoDebt, Inc.:

Operating Income = $19.50 million
Total Assets = $60.00 million
Value of Equity = $60.00 million

Net Income = (Operating Income - Interest Expense) * (1 - tax)
Net Income = ($19.50 million - $0 million) * (1 - 0.30)
Net Income = $19.50 million * 0.70
Net Income = $13.65 million

Return on Assets = Net Income / Total Assets
Return on Assets = $13.65 million / $60.00 million
Return on Assets = 22.75%

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