Debt versus Equity Financing 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 $600,000. AllDebt, Inc. finances its $1.2 million in assets with $1 million in debt (on which it pays 10 percent interest annually) and $.2 million in equity. AllEquity, Inc. finances its $1.2 million in assets with no debt and $1.2 million in equity. Both firms pay a tax rate of 30 percent on their taxable income. What are the asset funders' (the debt holders and stockholders') resulting return on assets for the two firms?
A) 29.17%, and 35%, respectively
B) 37.5%, and 35%, respectively
C) 37.5%, and 37.5%, respectively
D) 50%, and 50%, respectively

Question

Quizplus · Accepted Answer

AllDebt, Inc.: Operating income = $600,000; Interest = $100,000 (10% of $1,000,000); Taxable income = $500,000; Taxes = $150,000 (30% of $500,000); Net income = $350,000; Return on assets = $350,000 / $1,200,000 = 29.17%.  AllEquity, Inc.: Operating income = $600,000; No interest; Taxable income = $600,000; Taxes = $180,000 (30% of $600,000); Net income = $420,000; Return on assets = $420,000 / $1,200,000 = 35%.

Debt Versus Equity Financing You Are Considering a Stock Investment