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

For AllDebt, Inc., the interest expense is $600,000 * 5% = $30,000. The operating income is $400,000, so after interest, the income before taxes is $370,000. After a 30% tax, the net income is $259,000. The return on assets (ROA) is then $259,000 / $800,000 = 32.375%. For AllEquity, Inc., there's no interest expense, so the income before taxes is also $400,000. After a 30% tax, the net income is $280,000. The ROA is $280,000 / $800,000 = 35%. Therefore, the correct answer is 32.375% for AllDebt, Inc., and 35% for AllEquity, Inc., which corresponds to choice B.

You Are Considering a Stock Investment in One of Two