Spruce Grove Ltd.has total assets of $5 million and is currently financed entirely with equity.Spruce Grove Ltd.estimates that it could borrow money at a rate of 8%, and their current tax rate is 25%.Last year they earned net income of $200,000.What would their return on equity be if they financed their operations with 40% debt?

Question

Quizplus · Accepted Answer

The correct answer is B because the return on equity would increase from 4% to 8% if the company financed its operations with 40% debt. This is because the interest expense on the debt would be tax-deductible, which would reduce the company's taxable income and increase its net income.