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 $0.2 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. has an interest expense of $100,000 (10% of $1 million), leaving $500,000 in taxable income. After taxes (30%), the net income is $350,000. Return on assets (ROA) is $350,000 / $1.2 million = 29.17%. AllEquity, Inc. has no interest expense, so its taxable income is $600,000. After taxes, the net income is $420,000. ROA is $420,000 / $1.2 million = 35%.

Debt Versus Equity Financing You Are Considering a Stock Investment