FIT Corporation’s return on net operating assets (RNOA) is 10% and its tax rate is 40%. Its net operating assets ($4 million) are financed entirely by common shareholders’ equity. Management is considering its options to finance an expansion costing $2 million. It expects return on net operating assets to remain unchanged. There are two alternatives to finance the expansion:
1. Issue $1 million bonds with 12% coupon, and $1 million common stock.
2. Issue $2 million bonds with 12% coupon.
a. Determine net operating income after tax (NOPAT) and net income for each alternative.
b. Compute return on common shareholders’ equity for each alternative (use ending equity).
c. Calculate the assets-to-equity ratio for each alternative.
d. Compute return on net operating assets and explain how the level of leverage interacts with it in helping determine which alternative management should pursue.