What is the proportion of debt financing for a firm that expects a 35% return on equity, a 20% return on assets, and a 15% return on debt? Ignore taxes.
A)15%
B)25%
C)75%
D)80%

Question

Quizplus · Accepted Answer

The proportion of debt financing can be calculated using the formula: 
Return on assets = (Return on equity x Equity proportion) + (Return on debt x Debt proportion). 
Plugging in the given values and solving for Debt proportion, we get: 
20% = (35% x Equity proportion) + (15% x Debt proportion) 
Solving for Debt proportion, we get: 
Debt proportion = (20% - 35% x Equity proportion)/15% 
Since the return on equity is higher than the return on debt, we can assume that the firm would want to maximize its use of debt financing. At maximum debt financing, the equity proportion would be 0, and the debt proportion would be (20%/15%) = 133.33%, which is impossible. Therefore, the debt proportion must be less than 100%, and the closest option is 75%.

What Is the Proportion of Debt Financing for a Firm