Structon Company, which is just being formed, needs $1.4 million of assets (Tota
ID: 2683439 • Letter: S
Question
Structon Company, which is just being formed, needs $1.4 million of assets (Total Assets =$1.4M).It expects to have a basic earning power ratio of 22%. (Basic Earning ratio = EBIT/(Total Assets)=0.22).
The company will own no securities, so all of its income will be operating income.
Assume a 40% federal-plus-state tax rate on all taxable income.
a/ If the company is financed entirely with common stocks, what would be the ROE?
b/ If the company is financed at 35% with debt and 65% with stocks, what would be the ROE?.
Explanation / Answer
Return on common equity (ROE) = Net income available to common stockholders/Common equity We have EBIT/TA = 22% So EBIT = 22%*$1.4M = $308,000 SO Net Income = (1-T)*EBIT = (1-40%)* $308,000 = $184,800 a. ROE = $184,800 /1.4M = 13.20% b. ROE = $184,800/(65%*1.4M) = 20.31%