There are two firms: Firm U and Firm L. Both firms have $100M total assets and $
ID: 2719383 • Letter: T
Question
There are two firms: Firm U and Firm L. Both firms have $100M total assets and $30M EBIT (earnings before interest and taxes). Firm U is an unleveraged firm without debt. Firm L is a leveraged firm with 50% of debt and 50% of common equity. The pre-tax cost of debt for Firm L is 10%. Both firms have 30% corporate tax rate. Calculate the return on equity (ROE) for the unleveraged firm U ______
18%
21%
35%
40%
Based on the information from above Question . Calculate the return on equity (ROE) for the leveraged firm L ______
18%
21%
35%
40%
35%
40%
Explanation / Answer
Calculating return on equity for unleveraged firm U
Since no debt therefore no interest therefore Earnings after tax = $30M - [$30M * 30%] = $21Million
Return on equity = $21 million*100/$100 million = 21%
Calculating return on equity for leveraged firm L
EBIT = $30 million
50% financed by debt i.e. 100 million * 50% = $50 million
Interest = $50 million *10% = $5 million
Earnings before tax = $30 million - $5 million = $25 million
Therefore earnings after tax = $25 million * (25 million * 30%) = $17.5 million
50% equity = $100 million * 50% = $50 million
Return on equity on leveraged firm = $17.5 million/$50 million = 35%