Question
Declan Ross wants to sell his business. The firm has no debt and earns a 7% return (ROE) on equity of $160,000. The company can
Declan Ross wants to sell his business. The firm has no debt and earns a 7% return (ROE) on equity of $160,000. The company can borrow at an after-tax rate of 5%. A consultant has advised that the business will be worth more if its financial statements show a higher return on equity (ROE = net income/equity). Unfortunately, an increase in profitability isn't feasible. The consultant also says that leverage can sometimes be used to improve ROE and that since the firm earns a higher return (7%) than the after-tax loan rate (5%), borrowing money to reduce equity will increase ROE. How much will Declan have to borrow to raise his firm's ROE to 11%? (Hint: First calculate net income using the definition of ROE. Then assume Declan borrows $30,000, reducing equity by the same amount. Recalculate net income and ROE. Repeat with different debt amounts until ROE is close to 11%.) Round the answer to the nearest thousand dollars.
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access with AI-Powered Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started