Question

How would Skaters World, Inc.'s return on equity (ROE) be different if the company were to issue $200,000 of 10% bonds instead of $200,000 in stock? Assume income before interest and taxes is estimated to be $100,000, income taxes are 35% and stockholders' equity is initially $300,000.
a. ROE would be the same.
b. ROE would be higher with bonds.
c. ROE would be lower with bonds.

Answer 1

Answer:

B) ROE would be higher with bonds.

Explanation:

If the company issued $200,000 bonds with 10% interest rate, the return on equity (ROE) would be:

EBIT = $100,000

interests = ($20,000)

net income = (ebit - interest) x (1 - 35%) = ($100,000 - $20,000) x 65% = $80,000 x 65% = $52,000

ROE = $52,000 / $300,000 = 17.3%

If the company issued $200,000 in new stocks, the return on equity (ROE) would be:

EBIT = $100,000

net income = ebit x (1 - 35%) = $100,000 x 65% = $65,000

ROE = $65,000 / $500,000 = 13%