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 $400,000.AllDebt,Inc.finances its $800,000 in assets with $600,000 in debt (on which it pays 5 percent interest annually)and $200,000 in equity.AllEquity,Inc.finances its $800,000 in assets with no debt and $800,000 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)32.375%, and 35.00%, respectively
B)36.125%, and 35.00%, respectively
C)46.25%, and 50%, respectively
D)50%, and 50%, respectively

Question

Quizplus · Accepted Answer

To calculate the return on assets (ROA) for each company, we need to find their operating income after interest expenses and taxes, and divide it by their total assets:

ROAAllDebt = ($400,000 - ($600,000 x 5%)) x (1-30%) / $800,000 = 3.125% x 0.7 / 1 = 2.1875%

ROAAllEquity = $400,000 x (1-30%) / $800,000 = 2.8% x 0.7 / 1 = 1.96%

Therefore, the asset funders' return on assets for AllDebt is 2.1875%, and for AllEquity is 1.96%.

The better choice for investment depends on the investor's risk preference. AllEquity has a lower return on assets, but also no debt, which makes it less risky in case of financial difficulties. AllDebt has a higher return on assets, but also higher leverage and interest expenses, which increase its risk. Ultimately, the choice depends on the investor's risk tolerance and investment objectives.

Debt Versus Equity Financing You Are Considering a Stock Investment