Question
This week's assignment will examine how using debt can affect an organization's returns, further increasing returns during periods of growth, but further decreasing returns during
This week's assignment will examine how using debt can affect an organization's returns, further increasing returns during periods of growth, but further decreasing returns during recessionary periods. As you can see by looking at the table below, we have two firms, one of which does not use debt (Firm U) and a firm that uses debt (Firm L). For this week's assignment, solve for each organization's returns during periods of expected growth and during periods of bad growth. Assume a 40% tax rate and a 15% interest rate. Recall from prior chapters, return on equity (ROE) can be solved for as net income divided by equity, or NI/E (as you know, E can be found in each firm's balance sheet found above its income statement). As you can see, debt is truly a double-edged sword!
PS - Please highlight all four answers and show your calculations. Thanks!
Cheers,
Dr. G
Firm U (unleveraged) | Firm L (Leveraged) | |||||||
CA | 50 | Debt | 0 | CA | 50 | Debt | 50 | |
FA | 50 | Equity | 100 | FA | 50 | Equity | 50 | |
TA | 100 | 100 | TA | 100 | 100 | |||
Expected | Bad | Expected | Bad | |||||
Sales | 100 | 82.5 | Sales | 100 | 82.5 | |||
OperCosts | 70 | 80 | OperCosts | 70 | 80 | |||
EBIT | 30 | 2.5 | EBIT | 30 | 2.5 | |||
Interest | Interest | |||||||
EBT | 30 | 2.5 | EBT | 22.5 | -5 | |||
Taxes | Taxes | |||||||
Net Inc | Net Inc |
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