Finance homework problem

Question

Company has a target capital structure as follows: 60% debt and 40% from common equity. There is no preferred stock. Company is planning to make and sell a new product and this operation needs a capital of $15 million. Company can borrow at 8% and its effective tax rate is 30%. The new product will bring EBIT of $2 million.
Calculate the ROE for this.

Answer 1

Let’s take this in steps.

First what does the balance sheet look like?
Total assets= given at $15 million
Liabilities and equity 60% and 40% so that is $9 million debt and $6 million in equity

What did it make?
EBIT is projected at $2 million
Less,      interest expense?  $.720 million     (Easy at $9 million principle x 8% interest rate = $.720 million)
=Pretax    $1.28 million               ($2.0 million EBIT - $.720 million interest= $1.28 million)
Tax at 30%= $.38 million             ($1.28 million pretax X 30% tax rate= $.38 million tax due)
Net $.90 to the stockholders.        ($1.28 million pretax- $.38 Tax= $.90 net)
ROE= net/ equity= 15%               ( $.90 Million net profit/$6.0 million equity investment= 15%)