Explanation:
Initial Situation:
$20.0 million$10.0 million$20.0M - $10.0M = $10.0 million$20.0M/$10.0M = 2.0After Additional Borrowing:
$6.0 million$10.0M + $6.0M = $16.0 million$6.0 million (since borrowed money is invested)$20.0M + $6.0M = $26.0 million$10.0 million (no new equity issued)New Leverage:
$26.0M/$10.0M = 2.6New ROE Calculation:
$26.0M × 9.0% = $2.34 million$16.0M × 4.0% = $0.64 million$2.34M - $0.64M = $1.70 million$1.70M/$10.0M = 17.0%Therefore, the correct answer is Leverage = 2.6 and ROE = 17.0%.
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Suppose a firm with a simple capital structure has assets of $20.0 million and debt of $10.0 million. Return on assets (ROA) is 9.0% and cost of debt is 4.0%, such that the firm's leverage is 2.0 and its return on equity (ROE) is 14.0%. If the firm borrows an additional $6.0 million at the same cost of 4.0%, and asset returns are fixed, what is the firm's new leverage and return on equity (ROE)?
A
Leverage = 1.7 and ROE = 13.3%.
B
Leverage = 2.0 and ROE = 15.7%.
C
Leverage = 2.3 and ROE = 23.5%.
D
Leverage = 2.6 and ROE = 17.0%.
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