Homework SourseYou were hired as the CFO of a new company that was founded
You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm\'s expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROE L - ROE U?
0% Debt, U
60% Debt, L
24,000
24,000
$250.00
$250.00
$1,000,000
$1,000,000
$200.00
$200.00
$2,500,000
$2,500,000
0.00%
60.00%
$0
$1,500,000
$2,500,000
$1,000,000
NA
10.00%
35.00%
35.00%
–1.62%
–1.99%
–1.52%
–1.77%
–1.95%
| 0% Debt, U | 60% Debt, L | ||
| Expected unit sales (Q) | 24,000 | 24,000 | |
| Price per phone (P) | $250.00 | $250.00 | |
| Fixed costs (F) | $1,000,000 | $1,000,000 | |
| Variable cost/unit (V) | $200.00 | $200.00 | |
| Required investment | $2,500,000 | $2,500,000 | |
| % Debt | 0.00% | 60.00% | |
| Debt, $ | $0 | $1,500,000 | |
| Equity, $ | $2,500,000 | $1,000,000 | |
| Interest rate | NA | 10.00% | |
| Tax rate | 35.00% | 35.00% | |
Solution
0% Debt, U 60% Debt, L
Expected unit sales 24,000 24,000
Price per phone $250.00 $250.00
Fixed operating costs $1,000,000 $1,000,000
Variable operating cost/unit $200.00 $200.00
Required investment $2,500,000 $2,500,000
% Debt 0.00% 60.00%
Debt, $ $0 $1,500,000
Equity, $ $2,500,000 $1,000,000
Interest rate NA 10.00%
Tax rate 35.00% 35.00%
Sales revenues $6,000,000 $6,000,000
Fixed costs 1,000,000 1,000,000
Variable costs 4,800,000 4,800,000
Operating income $200,000 $200,000
Interest 0 150,000
Taxable income $200,000 $50,000
Taxes 70,000 17,500
Net income $130,000 $32,500
ROE 5.20% 3.25%
Difference in ROEs = –1.95%
Option \"E\" is correct.
