Commonwealth construction (cc) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 35%. cc will own no securities, so all of its income will be operating income. if it so chooses, cc can finance up to 30% of its assets with debt, which will have an 8% interest rate. if it chooses to use debt, the firm will finance using only debt and common equity, so no preferred stock will be used. assuming a 40% tax rate on all taxable income, what is the difference between cc’s expected roe if it finances these assets with 30% debt versus its expected roe if it finances these assets entirely with common stock?

The difference of the ROE between financing with 30% debt and the ROE of financing only with common stocks is 0.07, in favor of financing with debt.

This difference is because it has an operational leverage: the return on assets is bigger than the interest paid for debt.

Explanation:

We have to calculate the return on equity (ROE) for two situations:

1) No debt

In this case, all $3 millions of assets will be financed by common equity.

The EBT can be calculated as

Then, if we take into account the tax rate, we calculate the earnings after tax:

The ROE in this case is

The return on equity (ROE) is 21% or $0.21 per $1 of equity.

2) With 30% debt

In this case, the assets are financed 30% by debt and 70% by common stocks.

The annual interest of this debt are

We can calculate now the EBT

And the earning after tax

The ROE in this case is

The return on equity (ROE) is 28% or $0.28 per $1 of equity.

The difference is because it has an operational leverage: the return on assets is bigger than the interest paid for debt.

answer; (c) penalty

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