Question: Warren Brown is the founder of Cake Love. Assume that his company currently has $250,000 in equity, and he is considering a $100,000 expansion to meet increased demand. The $100,000 expansion would yield $16,000 in additional annual income before interest expense. Assume that the business currently earns $40,000 annual income before interest expense of $10,000, yielding a return on equity of 12% ($30,000y$250,000). To fund the expansion, he is 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 the expansion if interest on the $100,000 note is (a) 10%, (b) 15%, (c) 16%, (d) 17%, and (e) 20%.
2. What general rule do the results in part 1 illustrate?