Question

BTN 14-8 Mark and Holly Melton are entrepreneurs and owners of Melton Franchise Systems. Assume that Meltons' franchise program currently has $250,000 in equity; and they are considering a $100,000 expansion to meet increased demand. The $100,000 expansion would yield $16,000 in addi- tional annual income before interest expense. Assume that Meltons' franchise program currently earns $40,000 annual income before interest expense of $10,000, yielding a return on equity of 12% ($30,000/$250,000). To fund the expansion, the Meltons are considering the issuance of a 10-year, $100,000 note with annual interest payments (the principal due at the end of 10 years). Required 1. Using return on equity as the decision criterion, show computations to support or reject Meltons' expansion if interest on the $100,000 note is (a) 10%, (b) 15%, (c) 16%, (d) 17%, and (c) 20%. 2. What general rule do the results in part 1 illustrate?

Answer 1

Answer to question 1
	Return on Equity under different interest rate
		Different interest rate
		10%	15%	16%	17%	20%
	Interest expense on $ 100000 note	10000	15000	16000	17000	20000
	Additional income before interest expense due to expansion	16000	16000	16000	16000	16000
	Additional income after interest expense due to expansion	6000	1000	0	-1000	-4000
	Annual income after interest expense for current year's	30000	30000	30000	30000	30000
	Total income after interest expense	36000	31000	30000	29000	26000
	Equity	250000	250000	250000	250000	250000
	Return on Equity under different interest rate	14.40%	12.40%	12.00%	11.60%	10.40%
Answer to question 2
	As, it is observed from from above calculation return on equity keep going down with effect of positive increase in interest rate.