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

For AllDebt, Inc., the interest expense is $1 million * 10% = $100,000. The operating income is $600,000, so after paying interest, the pre-tax income is $600,000 - $100,000 = $500,000. After a 30% tax, the net income is $500,000 * (1 - 0.30) = $350,000. The return on assets (ROA) is then $350,000 / $1.2 million = 29.17%.For AllEquity, Inc., there is no interest expense, so the pre-tax income is the operating income of $600,000. After a 30% tax, the net income is $600,000 * (1 - 0.30) = $420,000. The ROA is then $420,000 / $1.2 million = 35%.Therefore, the correct answer is that the asset funders' resulting return on assets for AllDebt, Inc. and AllEquity, Inc. are 29.17% and 35%, respectively.

You Are Considering a Stock Investment in One of Two