Question

25. Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt--HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs?

Applicable to Both Firms Firm HD's Data Firm LD's Data

$200 Debt ratio 50% Debt ratio 30%

$40 Interest rate 12% Interest rate 10%

35%

2.18%

2.29%

2.41%

2.54%

2.66%

Answer 1

Answer: 2.41%

Explanation:

HD Equity = 200 * 50% = $100

LD Equity = 200 * (1 - 30%) = $140

HD Debt = 200 * 50% = $100

LD Debt = 200 * 30% = $60

Interest HD = 100 * 12% = $12

Interest LD = 60 * 10% = $6

ROE = Net Income/ Equity

                                           HD                            LD

EBIT                                    $40                        $40

Less: Interest                        12                             6

EBT                                     $28                         $34

Less taxes:                      (35% * 28)               (35% * 34)

Net Income                      $18.20                     $22.10

HD ROE = 18.20/100 = 18.2%

LD ROE = 22.10/140 = 15.79%

Difference:

= 18.2 - 15.79

= 2.41%