A Leverage and ROE Firm A uses debt and has 550 in equity Fi

A.

Leverage and ROE Firm A uses debt and has $550 in equity. Firm B does not use debt and has $1,030 in equity. Both firms pay a 34% tax rate and both firms have EBIT of $54. Firm A has interest expense of $35. There are no other expenses. If EBIT doubles for both firms ROE for Firm A will be_______; ROE for Firm B will be _______.

8.36%; 6.42%

10.26%; 6.62%

9.46%; 7.72%

8.76%; 6.92%

B.

Ratios Using the data provided below calculate the Tax Burden ratio.

68%

71%

66%

59%

Solution

Question 1)

ROE = Net Income/Equity

For calculating the ROE of 2 firms, we first need to calculate their Net Income, given Equity is already given.

Net Income = Pretax Income * (1 - Tax Rate)

Pretax Income = EBIT - Interest Expense

=> Net Income = (EBIT - Interest Expense) * (1 - Tax Rate)

Now, EBIT for both firm has doubled, therefore, it is $108 for both firms

For Firm A, Net Income = (108 - 35) * (1 - 34%) = 48.18

For Firm B, Net Income = (108 - 0) * (1 - 34%) = 71.28

ROE for Firsm A = 48.18/550 = 8.76%

ROE for Firsm A = 71.28/1,030 = 6.92%

So, answer is Option 4

Question 2

Tax Burden ratio = Net Income/Pretax Income

Pretax Income = EBIT - Interest Expense = 54 - 19 = 35

Tax Burden Ratio = Net Income/Pretax Income = 25/35 = 71.42% (Answer is 71%)