Roll Corporation’s return on net operating assets (RNOA) is 10% and its tax rate is 40%. Its net operating assets ($10 million) are financed entirely by common shareholders’ equity. Management is considering using bonds to finance an expansion costing $6 million. It expects return on net operating assets to remain unchanged. There are two alternatives to finance the expansion:
1. Issue $2 million bonds with 5% coupon and $4 million common stock.
2. Issue $6 million bonds with 6% coupon.
a. Compute Roll’s current net operating income after tax (NOPAT) and net income.
b. Determine net income and net operating income after tax for each alternative financing plan.
c. Compute return on common shareholders’ equity for each alternative (use ending equity).
d. Explain any difference in the ROCE for the alternative plans computed in (c). Include a discussion of leverage in your response.