Question

Garrett Camp and Travis Kalanick are the founders of Uber. Assume that the company currently has \(250,000 in equity and is considering a \)100,000 expansion to meet increased demand. The \(100,000 expansion would yield \)16,000 in additional annual income before interest expense. Assume that the business currently earns \(40,000 annual income before interest expense of \)10,000, yielding a return on equity of 12% (\(30,000/\)250,000). To fund the expansion, the company is considering the issuance of a 10-year, \(100,000 note with annual interest payments (the principal due at the end of 10 years).

Required

1. Using return on equity as the decision criterion, show computations to support or reject the expansion if interest on the \)100,000 note is (a) 10%, (b) 15%, (c) 16%, (d) 17%, and (e) 20%.
2. What general rule do the results in part 1 illustrate?

Short answer

a) Return on equity is highest with a 10% note

b) The company should consider any potential variability in its income predictions.

Step-by-step solution

Meaning of Return on equity (ROE)

Return on value (ROE) may be a metric utilized to survey how well a company uses equity or the stores its stockholders give and aggregate retained earnings to create income. In other words, ROE appears how well a trade can change over value investment into net profit.

(a) Showing the computation.

Particulars	Current	10% Note	15% Note	16% Note	17% Note	20% Note
Income before interest	$40,000	$56,000	$56,000	$56,000	$56,000	$56,000
Interest expense	10,000	20,000	25,000	26,000	27,000	30,000
Net income	$30,000	$36,000	$31,000	$30,000	$29,000	$26,000
Equity	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000
Return on Equity	12%	14.4%	12.4%	12%	11.6%	10.4%

(b) Explaining the general rules

The analysis in Part 1 is an example of the general principle, commonly known as "financial leverage" or "trading on equity": A firm's return on equity increases when it makes more money with borrowed funds than it is spending on interest. By dividing its anticipated $16,000 extra in annual income before interest by its $100,000 investment, this corporation estimates a return on investment of 16 percent. This indicates that the interest rate on the borrowed money must be lower than 16 percent for it to proceed with the investment.

The table in Part 1 reveals this result, where those notes with interest expense below 16% are profitable (that is, yield a return greater than the current ROE of 12%), while those above 16% are not (that is, yield a return less than the current ROE of 12%). Also, the company should consider any potential variability in its income predictions because any downturn in income that results in a return on equity lower than the interest rate paid on the notes would be unprofitable.