You are considering a stock investment in one of two firms (AllDebt, Inc. and AllEquity, Inc.), both of which operate in the same industry and have identical operating income of $3 million. AllDebt, Inc. finances its $6 million in assets with $5 million in debt (on which it pays 5 percent interest annually) and $1 million in equity. AllEquity, Inc. finances its $6 million in assets with no debt and $6 million in equity. Both firms pay a tax rate of 40 percent on their taxable income. What are the asset funders' (the debt holders and stockholders) resulting return on assets for the two firms?
A) 27.5%, and 30%, respectively
B) 31.67%, and 30%, respectively
C) 33%, and 30%, respectively
D) 50%, and 50%, respectively

Question

Quizplus · Accepted Answer

AllDebt, Inc.: Operating income = $3 million, Interest = $5 million * 5% = $0.25 million, Taxable income = $3 million - $0.25 million = $2.75 million, Taxes = $2.75 million * 40% = $1.1 million, Net income = $2.75 million - $1.1 million = $1.65 million. Return on assets = Net income / Total assets = $1.65 million / $6 million = 27.5%.  AllEquity, Inc.: Operating income = $3 million, Taxes = $3 million * 40% = $1.2 million, Net income = $3 million - $1.2 million = $1.8 million. Return on assets = Net income / Total assets = $1.8 million / $6 million = 30%.

You Are Considering a Stock Investment in One of Two