Jimbob Co.is considering ways to finance a planned business expansion after which the company will have $150,000 in earnings before interest and income taxes.The income tax rate is 30%.One alternative being considered is to issue new long-term debt of $500,000 with an annual interest rate of 8%.The company's common shareholders' equity is expected to average $500,000.What will be the return on common shareholders' equity if this alternative is taken?
A) 0%.
B) 10.5%.
C) 15.4%.
D) 30%.

Question

Quizplus · Accepted Answer

To calculate the return on common shareholders' equity (ROE), we need to subtract the after-tax interest expense on the new debt from the earnings before interest and taxes (EBIT), and then divide by the average common shareholders' equity.

After-tax interest expense = 0.08 x $500,000 x (1-0.30) = $28,000

EBIT - After-tax interest expense = $150,000 - $28,000 = $122,000

ROE = $122,000 / $500,000 = 0.244 or 24.4%

However, this calculation assumes that the new debt is used to finance the expansion, and that the earnings will increase by enough to cover the interest expense. It also assumes that there are no other costs or risks associated with the new debt. Therefore, while C is the correct answer based on the information given, it may not be the best choice in real-world situations where other factors should be considered.

Jimbob CoIs Considering Ways to Finance a Planned Business Expansion After