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 $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

For AllDebt, Inc.:

- Operating Income = $3 million
- Interest Expense = 5% of $5 million = $250,000
- Taxable Income = Operating Income - Interest Expense = $2.75 million
- Taxes = 40% x $2.75 million = $1.1 million
- Net Income to Equity = Operating Income - Interest Expense - Taxes = $1.6 million
- Return on Assets = Net Income to Equity / Total Assets = $1.6 million / $6 million = 26.67%

However, since the debt holders also receive a return of 5% on their investment, the total return on assets to all funders is:

- Return on Assets = Net Income to Equity + Interest Expense / Total Assets = ($1.6 million + $250,000) / $6 million = 31.67%

For AllEquity, Inc.:

- Operating Income = $3 million
- Taxes = 40% x $3 million = $1.2 million
- Net Income to Equity = Operating Income - Taxes = $1.8 million
- Return on Assets = Net Income to Equity / Total Assets = $1.8 million / $6 million = 30%

Therefore, the best choice would be to invest in AllDebt, Inc. as it provides a higher return on assets to all funders. However, it is important to note that taking on debt also comes with risks, such as the possibility of default or bankruptcy.

Debt Versus Equity Financing You Are Considering a Stock Investment