Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms' operations are identical--they have the same total investor-supplied capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (wd). Based on the following data, how much higher or lower is A's ROE than that of NA, i. e., what is ROEA - ROENA? Applicable to Both Firms Firm A's Data Firm NA's Data
Capital $180,000 50% 0%
EBIT $40,000 Int. rate 12% Int. rate 0%
Tax rate 35%
A) 10.25%.
B) 12.01%.
C) 10.35%.
D) 12.12%.
E) 12.84%.

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Explanation:

First and foremost, we need to determine the net income for both companies bearing in mind that the for firm A interest expense is 12% of debt capital whereas debt capital is 50% of total capital of $180,000 since the  debt ratio(debt/total capital) of firm of Firm A is 50% and 0% for Firm NA

EBIT=$40,000

tax rate=35%

Firm A:

Debt capital=50%*$180,000=$90,000

Equity=50%*$180,000=$90,000

interest expense=$90,000*12%

interest expense=$10,800

Earnings before tax=$40,000-$10,800=$29,200

net income=earnings before-tax*(1-tax rate)

net income=$29,200*(1-35%)

net income=$18,980

return on equity=net income/equity

return on equity=$18,980/$90,000

return on equity=21.09%

Firm NA:

Equity=$180,000

debt=0%

EBIT=$40,000

no debt, no interest expense

net income=$40,000*(1-35%)

net income=$26,000

return on equity=$26,000/$180,000

return on equity=14.44%

ROEA - ROENA=21.09%-14.44%=6.65%

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