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There are two firms: Firm U and Firm L
There are two firms: Firm U and Firm L. Both firms have $100M total assets and $15M EBIT (earnings before interest and taxes). Firm U is an unleveraged firm without debt. Firm L is a leveraged firm with 50% of debt and 50% of common equity. The pre-tax cost of debt for Firm L is 10%. Both firms have 30% corporate tax rate. Calculate the return on equity (ROE) for firm U
10.0%
11.5%
14.0%
16.2%
Expert Solution
Computation of Return on Equity (ROE) for Firm U:
Return on equity (ROE) for firm U = Net income / Equity
Here,
a) Net income = EBIT * (1 - Tax rate @ 30% or 0.30)
Net income = $15 Million * (1 - 0.30)
Net income = $10.50 Million
b) Total assets = Total liabilities & Equity
As it is unlevered firm, so there is no debt or liabilities.
Total assets = Equity = $100 Million
Now put the values into formula,
ROE for firm U = $10.50 million / $100 million
ROE for firm U = 0.01050 or 10.50%
So, Return on Equity (ROE) for Firm U is 10.50% which is not given in the options. May be there is some mistake in options.
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