QUESTION 1
TABLE 1 (Option)
Funded by equity only
Total assets R600 million:
Equity R600 million (R400 m + R200 m)
Debt R0 million
Rm
Earnings before interest & tax (EBIT) (115 x 1.10) 126.50
Interest 0.0
Profit before tax 126.50
Income tax expense @ 28% (35.42)
(a) Net profit 91.08
(b) Return on assets (ROA) = Net profit/Total Assets
= R91.08m/R600m x 100% = 15.18%
(c) Return on equity (ROE) = Net profit/Total Equity
= R91.08/R600m x 100% = 15.18%
, TABLE 2 (Option 2)
50% equity and 50% debt funding
Total assets R600 million:
Equity R500 million (R400 m + R100 m)
Debt R100 million
Rm
Earnings before interest & tax (EBIT) (115 x 1.10) 126.50
Interest (9)
Profit before tax 117.50
Income tax expense @ 28% (32.90)
(a) Net profit 84.60
(b) Return on assets (ROA) = Net profit/Total Assets
= R84.60m/R600m x 100% = 14.10%
(c) Return on equity (ROE) = Net profit/Total Equity
= R84.60/R500m x 100% = 16.92%
d) Give a short explanation why the inclusion of debt funding (option 2) increases the
return on equity (ROE).
• The returns for equity holders (measured in the Return on Equity) increase when
expansion is funded by debt. This is called the leverage effect
• Since equity is equal to assets minus total debt, a company can decrease its equity
as a percentage of its assets by increasing its debt.
• Assets, the numerator of the financial-leverage figure; increases, so the overall
financial-leverage number rises, boosting ROE
= R91.08m/R600m x 100
TABLE 1 (Option)
Funded by equity only
Total assets R600 million:
Equity R600 million (R400 m + R200 m)
Debt R0 million
Rm
Earnings before interest & tax (EBIT) (115 x 1.10) 126.50
Interest 0.0
Profit before tax 126.50
Income tax expense @ 28% (35.42)
(a) Net profit 91.08
(b) Return on assets (ROA) = Net profit/Total Assets
= R91.08m/R600m x 100% = 15.18%
(c) Return on equity (ROE) = Net profit/Total Equity
= R91.08/R600m x 100% = 15.18%
, TABLE 2 (Option 2)
50% equity and 50% debt funding
Total assets R600 million:
Equity R500 million (R400 m + R100 m)
Debt R100 million
Rm
Earnings before interest & tax (EBIT) (115 x 1.10) 126.50
Interest (9)
Profit before tax 117.50
Income tax expense @ 28% (32.90)
(a) Net profit 84.60
(b) Return on assets (ROA) = Net profit/Total Assets
= R84.60m/R600m x 100% = 14.10%
(c) Return on equity (ROE) = Net profit/Total Equity
= R84.60/R500m x 100% = 16.92%
d) Give a short explanation why the inclusion of debt funding (option 2) increases the
return on equity (ROE).
• The returns for equity holders (measured in the Return on Equity) increase when
expansion is funded by debt. This is called the leverage effect
• Since equity is equal to assets minus total debt, a company can decrease its equity
as a percentage of its assets by increasing its debt.
• Assets, the numerator of the financial-leverage figure; increases, so the overall
financial-leverage number rises, boosting ROE
= R91.08m/R600m x 100
