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Use debt or equity for better ROE

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Jenny Yu, the owner of the Honey Coffee Shop chain, has decided to expand her operations. Her 2007 financial statements follow. Jenny can buy two additional coffeehouses for $3 million, and she has the choice of completely financing these new coffeehouses with either a 10 percent (annual interest) loan or the issuance of new common stock. She also expects these new shops to generate an additional $1 million in sales. Assuming a 40 percent tax rate and no other changes, should Jenny buy the two coffeehouses? Why or why not? Which financing option results in the better ROE?

Honey Coffee Shops, Inc. 2007 Financial Statements

Balance Sheet Income Statement
Current assets $250,000 Sales $500,000
Fixed assets 750,000 Less Costs and Expenses @ 40%.. 200,000
Total assets $1,000,000 (EBIT) $300,000
Current liabilities $300,000 Less Interest expense 0
Long-term debt Net profit before taxes $300,000
Total liabilities $300,000 Less Taxes @ 40% 120,000
Common equity 700,000 Net income $180,000
Total liabilities and
stockholders' equity¦ $1,000,000.

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Solution Summary

The solution uses debt or equity for better ROE.

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Financing: Debt
Net income: [1,000,000*(1 - 40%) - 3,000,000*10%]*(1 - 40%) = 180,000
ROE: 180,000/700,000 = ...

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