Question

(Trading on the Equity Analysis) Presented below is information from the annual report of Emporia Plastics, Inc.

Operating income	\( 532,150
Bond interest expense	135,000
	397,150
Income taxes	183,432
Net income	\) 213,718
Bonds payable	$1,000,000
Common stock	875,000
Retained earnings	375,000

Instructions

1. Compute the return on common stockholders’ equity and the rate of interest paid on bonds. (Assume balances for debt and equity accounts approximate averages for the year.)
2. Is Emporia Plastics, Inc. trading on the equity successfully? Explain.

Short answer

The rate of return on common stock equity is 17.1%,and the rate of interest on bonds payable is13.5%.

Step-by-step solution

Meaning of Equity

Equity represents the value derived by the owners. Based on the company's balance sheet, the value of equity is determined as the difference between assets and liabilities. Themarket value of equity is determined by either the existing share price (if publicly traded) or by the valuation of a professional.

Computing the return on common stockholders’ equity and the rates of interest paid on bonds.

$\begin{array}{rcl}\mathbf{Return}\mathbf{}\mathbf{on}\mathbf{}\mathbf{Common}\mathbf{}\mathbf{Stock}\mathbf{}\mathbf{Equity}& \mathbf{=}& \frac{\mathbf{Net}\mathbf{}\mathbf{Income}}{\mathbf{Common}\mathbf{}\mathbf{stock}\mathbf{+}\mathbf{Retained}\mathbf{}\mathbf{Earnings}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{213}\mathbf{,}\mathbf{718}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{250}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{17}\mathbf{.}\mathbf{1}\mathbf{\%}\end{array}$

$\begin{array}{rcl}\mathbf{Return}\mathbf{}\mathbf{on}\mathbf{}\mathbf{Bonds}\mathbf{}\mathbf{payable}& \mathbf{=}& \frac{\mathbf{Bonds}\mathbf{}\mathbf{Interest}\mathbf{}\mathbf{Expense}}{\mathbf{Bonds}\mathbf{}\mathbf{Payable}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{135}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{13}\mathbf{.}\mathbf{5}\mathbf{\%}\end{array}$

Explaining the trading on the equity of Emporia Plastics, Inc.

Emporia Plastics, Inc. is trading on the equity successfully since its return on common stock equity is greater than the interest paid on bonds.

Note: Some analysts use after-tax interest expense to compute the bond rate.