3. Fill in the table using the following information.
Assets required for operation: $10,000
Firm A uses only equity financing
Firm B uses 30% debt with a 6% interest rate and 70% equity
Firm C uses 50% debt with a 10% interest rate and 50% equity
Firm D uses 50% preferred stock financing with a dividend rate of 10%
and 50% equity financing
Earnings before interest and taxes: $1,000
A B C D
Debt outstanding $ $ $ $
Stockholders’ equity
Earnings before interest and taxes 300 300 300
Interest expense
Earnings before taxes
Taxes (40% of earnings)
Net earnings
Return on stockholders’ equity % % % %
What happens to the return on the stockholders’ investment as the
amount of debt increases? Why is the rate of interest greater in case C?
Why is the return lower when the firm uses preferred stock instead of
debt? Why does the use of preferred stock involve less risk for the firm
than a comparable use of debt financing?
