Stark Corp is in the process of acquiring another business. In light of the acquisition, shareholders are currently re-evaluating the appropriateness of the firm's capital structure (the types of and relative levels of debt and equity). The two proposals being contemplated are detailed below: Proposal 1Proposal 2Estimated earnings before interest and taxes (EBIT)$ 450,000$ 450,000Long term debt1,000,0002,000,000Market value of equity1,000,000500,000Interest rate on long term debt10%10%Tax rate25%25% RequiredCalculate the estimated return on equity (ROE) under the two proposals. (ROE = net income after taxes / market value of equity; net income after taxes = (EBIT - interest on long-term debt) × (1 - tax rate)).

Let's calculate the Return on Equity (ROE) for both proposals.Formula Breakdown:Net Income After…

Answered: Stark Corp is in the process of…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter13: Capital Structure Concepts

Section: Chapter Questions

Problem 5P

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Question

Stark Corp is in the process of acquiring another business. In light of the acquisition, shareholders are currently re-evaluating the appropriateness of the firm's capital structure (the types of and relative levels of debt and equity). The two proposals being contemplated are detailed below:

	Proposal 1	Proposal 2
Estimated earnings before interest and taxes (EBIT)	$ 450,000	$ 450,000
Long term debt	1,000,000	2,000,000
Market value of equity	1,000,000	500,000
Interest rate on long term debt	10%	10%
Tax rate	25%	25%

Required

Calculate the estimated return on equity (ROE) under the two proposals. (ROE = net income after taxes / market value of equity; net income after taxes = (EBIT - interest on long-term debt) × (1 - tax rate)).

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