Faber Products has $35 million of sales and $9.75 million of net income. Its total assets are $150 million. Assume the company’s total assets equal total invested capital, and its capital structure consists of 40% debt and 60% common equity. The firm’s interest rate is 4%, and its tax rate is 21%. What would happen if this firm used less leverage (debt)?

If the firm uses less leverage, its ROE will decrease since the cost of equity is much higher than the cost of debt. If all debt is eliminated, then ROE will decrease to 7.764% from 10.83%.

Explanation:

net income = $9.75 million

capital structure:

interest rate = 4% and tax rate = 21%

current return on equity (ROE) = $9.75 / $90 = 10.83%

current return of assets (ROA) = $9.75 / $150 = 6.5%

cost of debt = 4% x (1 - 21%) = 3.16%

if the company issues more equity to lower debt to 0, then:

net income = $9.75 + [$60 million x 4% x (1 - 21%)] = $9.75 + $1.896 = $11.646 million

return on equity (ROE) = $11.646 / $150 = 7.764%

return of assets (ROA) = $11.646 / $150 = 7.764%

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