RETURN ON EQUITY Central City Construction (CCC) needs $1 million of assets to get started, and it expects to have a basic earning power ratio of 20%. CCC will own no securities, so all of its income will be operating income. If it so chooses, CCC can finance up to 50% 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 willbe used. Assuming a 40% tax rate on all taxable income, what is the difference between CCC’s expected ROE if it finances these assets with 50% debt versus its expected ROE if it finances these assets entirely with common stock?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
be used. Assuming a 40% tax rate on all taxable income, what is the difference between CCC’s expected ROE if it finances these assets with 50% debt versus its expected ROE if it finances these assets entirely with common stock?
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