Answer:
b. 2.59%
Explanation:
The assets are 200,000
For Plan A
it will be 25% debt = 200,000 x 25% = 50,000
and 75% equity = 200,000 x 75% = 150,000
The debt will generate 8.8% interest expense
50,000 x 8.8% = 4,400
Income for the expected project under Plan A
sales revenue 300,000
operating cost 265,000
EBIT 35,000
interest expense 4,400
EBT 30,600
income tax 10,710
Net income 19,890
TE = times interest earned = EBIT /interest expense
35,000 / 4,400 = 7,95 It achieve the requirement of 4.5 or above
ROE for plan A net income / equity
19,890/150,000 = 0,1326 = 13.26%
Under Plan B
We will take as much debt as we can until TIE = 4.5
so:
EBIT / interest expense = TIE
35,000/interest expense = 4.5
35,000/4.5 = 7.777,78
This will be the interest expense for plan B
Now we calculate net income:
(EBIT - interest) x (1- tax-rate) = net income
(35,000 - 7,777.78) x (1-35%) = 17.694,443
and for the ROE for plan B first, we need to check the capital structure:
The interest expense are the 8.8% of the debt so
debt x rate = interest expense
interest expense / rate = debt
7,777.78/0.088 = 88.383,86
Asset = debt + equty
200,000 = 88,383.86 + equity
200,000 - 88,383.86 = equity = 111,616.14
Now, we got the capital structure
debt 88,383.86
equity 111,616.14
ROE for Plan B
17,694.443 / 111,616.14 = 0,15852943 = 15.85%
now we compare both ROE
Plan A 13.26%
Plan B 15.85%
Difference 2.59%
Using Plan B will increase the ROE for 2.59%
