Colborne Co.requires a $500,000 investment on which the partners expect to earn $50,000 before considering the cost of financing.The after-tax cost of debt is 6%.If the company decides to finance one-half of the investment with debt, how much greater will the returns to the shareholders be?

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Quizplus · Accepted Answer

Financing half of the investment with debt means $250,000 will be financed through debt. The after-tax cost of debt is 6%, so the cost of this debt is $250,000 * 6% = $15,000. The expected earnings are $50,000, so without debt, this entire amount would be available to shareholders. With debt, the earnings available to shareholders are $50,000 - $15,000 = $35,000. The difference in returns is $35,000 on a $250,000 equity investment (since half of the $500,000 investment is financed with debt), which is 14%. However, the question asks how much greater the returns to the shareholders will be due to using debt, which is calculated based on the cost savings from using debt, not the overall return rate. The cost of debt reduces the amount needed from shareholders, effectively increasing their return on investment. The calculation provided directly compares the cost savings to the initial investment, but the correct approach should consider the leverage effect. The error in the explanation is in misinterpreting the question's ask; it's about the incremental benefit to shareholders due to financing, not the direct calculation of returns. The correct interpretation involves understanding that financing with debt at a lower cost than the return on investment increases shareholder returns, but the calculation provided does not accurately capture the specific increase asked for in the question.