Suppose we have two identical companies with the same level of operating leverage $($same operating structure$),$ but different levels of financial leverage. Company A has no DEBT $($i$.$e$.$ it is $100\%$ equity financed$)$ so it has $$10,000,000$ in Book Value of Equity. Company B on the other hand has decided to add DEBT to its capital structure and therefore, has issued $$5,000,000$ in BANK LOANS that pay $10\%$ interest rate per year, it then used the proceeds from the sale to buy back $$5,000,000$ in shares from shareholders. Both companies have $$10,000,000$ in Total Assets.

Company A Company B

$(100\%$ Equity financed$)(50\%$ Equity, $50\%$ Debt$)$

Debt $0$ Debt $$5,000,000$

Book Value of Equity $$10,000,000$ Book Value of Equity $$5,000,000$

Total Assets $$10,000,000$ Total Assets $$10,000,000$

$30\%$ tax rate $30\%$ tax rate

$10\%$ interest rate

Sales and operating leverage are not affected by the financing decision. Hence, Earnings Before Interest and Taxes $($EBIT$)$ under both financing plans is identical to $$4,000,000.$ Both firms have a $30\%$ tax rate.

What is the difference in their Return on Equity $($ROE$)?($Hint: calculate the ROE for both companies and subtract one from the other, this is the difference$).($Enter your answer in percentage with two decimals, for example if your answer is $2\mathrm{.}15\%,$ enter $2\mathrm{.}15)$

Answer:Question $14$

Suppose we have two identical companies with the same level of operating leverage $($same operating structure$),$ but different levels of financial leverage. Company A has no DEBT $($i$.$e$.$ it is $\backslash (100\backslash \%\backslash )$ equity financed$)$ so it has $\backslash (\backslash$$ $10,000,000\backslash )$ in Book Value of Equity. Company B on the other hand has decided to add DEBT to its capital structure and therefore, has issued $\backslash$$$5,000,000$ in BANK LOANS that pay $\backslash (10\backslash \%\backslash )$ interest rate per year, it then used the proceeds from the sale to buy back $\backslash (\backslash$$ $5,000,000\backslash )$ in shares from shareholders. Both companies have $\backslash (\backslash$$ $10,000,000\backslash )$ in Total Assets.

Sales and operating leverage are not affected by the financing decision. Hence, Earnings Before Interest and Taxes $($EBIT$)$ under both financing plans is identical to $\backslash (\backslash$$ $4,000,000\backslash ).$ Both firms have a $\backslash (30\backslash \%\backslash )$ tax rate.

What is the difference in their Return on Equity $($ROE$)?($Hint: calculate the ROE for both companies and subtract one from the other, this is the difference$).($Enter your answer in percentage with two decimals, for example if your answer is $\backslash (2\mathrm{.}15\backslash \%\backslash ),$ enter $2\mathrm{.}15)$

Answer: