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Old Exam Questions  Financial Statements, Cash Flow, and Taxes  Solutions
Page 61 of 73 Pages
Total PV of EVA
2006
= $3,063,840 / (0.12  0.04) = $38,298,000
61.
Assume that your company is 60 percent equity financed (40 percent debt financed).
Given the following information, calculate the return on equity (ROE).
Data
Amount
EBIT
$6,000
Sales
$35,000
Interest Rate
0.06
Dividend payout ratio
40%
Total assets turnover
0.70 x
Tax rate
40%
A.
9.20%
B.
9.50%
C.
9.40%
D.
9.30%
*
E.
9.60%
TAT = 0.75 = Sales / TA
TA = Sales / TAT = $35,000 / 0.70 = $50,000
Debt = ($50,000)*(.40) = $20,000
Equity = ($50,000)*(.60) = $30,000
Interest Expense = ($20,000)*(0.06) = $1,200
EBIT
$6,000
Interest
$1,200
EBT
$4,800
Taxes
$1,920
Net Income
$2,880
ROE = $2,880 / $30,000 = 9.60%
62.
We discussed in class how the return on equity for a levered firm can be a function of
the return on assets of an equivalent unlevered firm, a leverage effect, and a tax
shelter effect. Assume that a firm starts out as an all equity firm with $10,000,000 of
common equity, $10,000,000 of assets, and a return on assets (ROA) of 14 percent.
Also assume that management makes the decision to issue $2,000,000 of debt (the
firm’s cost of debt is 8 percent), and to then use the proceeds to buy back $2,000,000
of common equity. Based on this information, and assuming that the firm’s tax rate is
40 percent, determine what the return on equity (ROE) will be after the buy back.
A.
15.05%
B.
17.55%
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View Full Document Old Exam Questions  Financial Statements, Cash Flow, and Taxes  Solutions
Page 62 of 73 Pages
C.
12.55%
*
D.
16.30%
E.
13.80%
Debty / Equity = $2,000,000 / $8,000,000 = .25
ROA = 14.0% (Given)
r
D
= 8.0% (Given)
Aftertax r
D
= (8.0%)*(1.40) = 4.,80%
Interest Expense = ($2,000,000)*(.08) = $160,000
Debt does create a leverage and a tax shelter effect, so
ROE = ROA (unlevered) + Leverage Effect + Tax Shelter Effect
ROE = 0.14 + (0.14  0.08)*(.25) + (0.08  0.048)*(.25)
ROE = 0.14 + 0.015 + 0.008 = 16.30%
Alternatively,
ROA = NI / TA
NI = (ROA)*(TA) = (0.14)*($10,000,000) = $1,400,000
Work backwards up through income statement to get EBIT:
EBIT
$2,333,333
Interest
 $ 0
EBT
$2,333,333
Taxes
 $ 933,333
Net Income
$1,400,000
Now consider the interest payment:
Interest Expense = ($2,000,000)*(0.08) = $160,000
EBIT
$2,333,333
Interest
 $ 160,000
EBT
$2,173,333
Taxes
 $ 869,333
Net Income
$1,304,000
NEW ROE = $1,304,000 / $8,000,000 = 16.30%
63.
Assume that Firm A is an allequity firm with total assets of $2,000 and the following
distribution of EBIT for the coming year:
Old Exam Questions  Financial Statements, Cash Flow, and Taxes  Solutions
Page 63 of 73 Pages
Economy
Firm A
(Unlevered)
Bad
Average
Good
Probability
30.00%
40.00%
30.00%
EBIT
$200.00
$240.00
$280.00
Interest
$0.00
$0.00
$0.00
EBT
$200.00
$240.00
$280.00
Taxes (40%)
$80.00
$96.00
$112.00
Net Income
$120.00
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.
 Spring '08
 Staff
 Debt, Interest, Return On Equity (ROE)

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