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    Rate of return

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    Laurel company has assets of $2 million and long-term, 10% debt of $1,200,000. Hardy Company has assets of $2 million and no long-term debt. The annual operating income (before interest) of both companies is $400,000. Ignore taxes.

    1. Compute the rate of return on
    a. assets
    b. stockholder equity.
    2. Evaluate the relative merits of each base for appraising operating management.

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    Solution Preview

    1a. Return on Assets = (Net Income + Interest X (1-tax rate)/Total Assets
    If we ignore taxes, then Net Income + Interest = Operating Income
    Return on Assets = Operating Income/Assets
    Since both companies have the same assets of $2 million and operating income of $400,000
    Return on Assets for both = 400,000/2,000,000 = 20%

    b. Return on Equity = Net Income/Total Equity
    Laurel Company
    Operating Income = 400,000
    Interest = 1,200,000 X 10% = 120,000
    Net Income = 280,000
    Total Assets = 2,000,000 (Debt + Equity)
    Debt financing = 1,200,000
    Equity financing = ...

    Solution Summary

    The solution explains the calculation of rate of return on assets and equity and the relative merits of each base