Structon Company, which is just being formed, needs $1 million of assets (Total
ID: 2683440 • Letter: S
Question
Structon Company, which is just being formed, needs $1 million of assets (Total Assets =$1M).It expects to have a basic earning power ratio of 20%. (Basic Earning ratio = EBIT/(Total Assets)=0.2).
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 50% with debt and 50% 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 = 20% So EBIT = 20%*$1M = $200,000 SO Net Income = (1-T)*EBIT = (1-40%)* $200,000 = $120,000 a. ROE = $120,000 /1M = 12% b. ROE = $120,000/(50%*1M) = 24%