You work for the CEO of a newly incorporated company that plans to acquire long-forgotten songs, like “Let’s Do Something Cheap and Superficial”, “Take This Job and Shove It”, and the “Mother-in-Law Song” and promote them to increase their popularity to earn royalties. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is the ROE when using financial leverage minus the ROE when using no financial leverage? 0% Debt 60% Debt Operating income (EBIT) $400,000 $400,000 Required investment $2,500,000 $2,500,000 % Debt Financing 0.0% 60.0% $ of Debt Financing $0.00 $1,500,000 $ of Common Equity Financing $2,500,000 $1,000,000 Interest rate NA 8.00% Tax rate 25% 25% 5.85% 6.14% 7.45% 8.77% 9.00%
2 - You work for the CEO of a newly incorporated company that plans to acquire long-forgotten songs, like “Let’s Do Something Cheap and Superficial”, “Take This Job and Shove It”, and the “Mother-in-Law Song” and promote them to increase their popularity to earn royalties. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is the ROE when using financial leverage minus the ROE when using no financial leverage?
|
|
0% Debt |
60% Debt |
|
Operating income (EBIT) |
$400,000 |
$400,000 |
|
Required investment |
$2,500,000 |
$2,500,000 |
|
% Debt Financing |
0.0% |
60.0% |
|
$ of Debt Financing |
$0.00 |
$1,500,000 |
|
$ of Common Equity Financing |
$2,500,000 |
$1,000,000 |
|
Interest rate |
NA |
8.00% |
|
Tax rate |
25% |
25% |
- 5.85%
- 6.14%
- 7.45%
- 8.77%
- 9.00%
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