CPA · Question 15 · Area I: Business Analysis
Management is deciding between two financing plans: Plan A (100% Equity) and Plan B (50% Debt, 50% Equity). Plan B involves issuing bonds with a 6% interest rate. The corporate tax rate is 25%. If the company expects its Return on Assets (ROA) to be 10% (before tax), which plan will result in a higher Return on Equity (ROE), and why?
Answer options:
Plan A, because it avoids interest expense.
Plan B, because the Return on Assets (10%) exceeds the after-tax cost of debt (4.5%).
Plan A, because financial leverage always increases risk without guaranteeing returns.
Plan B, because the interest tax shield increases Net Income compared to Plan A.
50 questions · hints · full answers · grading
Expert