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
b. stockholder equity.
2. Evaluate the relative merits of each base for appraising operating management.
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
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 = ...
The solution explains the calculation of rate of return on assets and equity and the relative merits of each base