Problem 20-05

You are given the following information concerning a firm: Assets required for operation: $5,600,000 Revenues: $8,700,000 Operating expenses: $8,150,000 Income tax rate: 40%.

Management faces three possible combinations of financing:

100% equity financing

25% debt financing with a 6% interest rate

50% debt financing with a 6% interest rate

What is the net income for each combination of debt and equity financing? Round your answers to the nearest dollar.

	1		2		3
Net income	$		$		$

What is the return on equity for each combination of debt and equity financing? Round your answers to one decimal place.

	1		2		3
Return on equity	%		%		%

If the interest rate had been 12 percent instead of 6 percent, what would be the return on equity for each combination of debt and equity financing? Round your answers to one decimal place.

	1		2		3
Return on equity	%		%		%

What is the implication of the use of financial leverage when interest rates change?

The use of financial leverage is likely to -Select-increasedecreaseItem 10 the return to the common stockholders if the rate of interest is low. If the rate of interest exceeds (after adjusting for taxes) the return earned on the borrowed funds, the return to the common stockholder is likely to -Select-increasedecreaseItem 11 by the use of financial leverage.