Financial Comparison of Debt Free, Inc. and Debt Spree, Inc.

Debt Free   Debt Spree

  Financial Comparison of Debt Free, Inc. and Debt Spree, Inc. In this analysis, we will evaluate two firms—Debt Free, Inc. and Debt Spree, Inc.—which differ primarily in their financing strategy, particularly in their use of debt. We will calculate their interest expenses, return on assets (ROA), net income, return on equity (ROE), and discuss which firm should have a higher Capital Asset Pricing Model (CAPM) β. a) Interest Expense Calculation The interest expense for each firm can be calculated using the formula: [ \text{Interest Expense} = \text{Debt} \times \text{Average Interest Rate} ] - Debt Free, Inc. - Debt: $0 - Interest Expense: (0 \times 0.16 = 0) - Debt Spree, Inc. - Debt: $150 - Interest Expense: (150 \times 0.16 = 24) b) Return on Assets (ROA) Calculation Return on Assets (ROA) is calculated as: [ \text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} ] To compute ROA, we first need net income, which we will calculate in the next section. c) Net Income Calculation Net Income can be derived from the formula: [ \text{Net Income} = \text{EBIT} - \text{Interest Expense} - \text{Taxes} ] Where: [ \text{Taxes} = (\text{EBIT} - \text{Interest Expense}) \times \text{Tax Rate} ] Bad Year - Debt Free, Inc. - EBIT: 12 - Interest Expense: 0 - Taxes: ( (12 - 0) \times 0.35 = 4.2 ) - Net Income: ( 12 - 0 - 4.2 = 7.8 ) - Debt Spree, Inc. - EBIT: 12 - Interest Expense: 24 - Taxes: ( (12 - 24) \times 0.35 = 0) (No taxes due to loss) - Net Income: ( 12 - 24 - 0 = -12 ) Normal Year - Debt Free, Inc. - EBIT: 38 - Interest Expense: 0 - Taxes: ( (38 - 0) \times 0.35 = 13.3 ) - Net Income: ( 38 - 0 - 13.3 = 24.7 ) - Debt Spree, Inc. - EBIT: 38 - Interest Expense: 24 - Taxes: ( (38 - 24) \times 0.35 = 4.9 ) - Net Income: ( 38 - 24 - 4.9 = 9.1 ) Good Year - Debt Free, Inc. - EBIT: 46 - Interest Expense: 0 - Taxes: ( (46 - 0) \times 0.35 = 16.1 ) - Net Income: ( 46 - 0 - 16.1 = 29.9 ) - Debt Spree, Inc. - EBIT: 46 - Interest Expense: 24 - Taxes: ( (46 - 24) \times 0.35 = 7.7 ) - Net Income: (46 - 24 -7.7 = 14.3 ) d) Return on Equity (ROE) Calculation Return on Equity (ROE) is calculated as: [ \text{ROE} = \frac{\text{Net Income}}{\text{Equity}} ] Bad Year - Debt Free, Inc.: [ ROE = \frac{7.8}{250} = 3.12% ] - Debt Spree, Inc.: [ ROE = \frac{-12}{100} = -12% ] Normal Year - Debt Free, Inc.: [ ROE = \frac{24.7}{250} = 9.88% ] - Debt Spree, Inc.: [ ROE = \frac{9.1}{100} = 9.1% ] Good Year - Debt Free, Inc.: [ ROE = \frac{29.9}{250} = 11.96% ] - Debt Spree, Inc.: [ ROE = \frac{14.3}{100} = 14.3% ] e) CAPM β Analysis Based on the information provided, Debt Spree, Inc., which employs more debt in its capital structure, is likely to have a higher CAPM β compared to Debt Free, Inc. The reasoning is as follows: 1. Financial Leverage: Higher debt increases financial risk due to fixed interest obligations, which can amplify earnings volatility. 2. Risk Perception: Investors typically perceive firms with higher debt levels as riskier because they have higher fixed costs and lower operational flexibility during downturns. 3. Industry Practice: In the same industry and lifecycle stage, firms that use more debt often face a higher required return from investors to compensate for the increased risk. Conclusion In conclusion, this analysis highlights the contrasting financial strategies of Debt Free and Debt Spree, with the latter bearing more risk due to its reliance on debt financing. While Debt Spree may exhibit higher ROE in good years, its increased financial risk raises concerns about sustainability during economic downturns, making it crucial for stakeholders to weigh the benefits of leverage against the inherent risks involved. This structured assessment underscores the significance of financial strategy in corporate performance and risk management, serving as a reminder for investors to consider both profitability and stability when evaluating potential investments.

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