Financial Management

Description

Question 1: Arrow Technology (ATI) has total assets of $10 million and expected operating income (EBIT) of $2.5 million. If ATI uses debt in its capital structure, the cost of debt will be 12% per annum.

• Complete the following table.

	Leverage Ratio (Debt / Total Assets)
	0%	25%	50%
Total assets
Debt (12%)
Equity
Total liabilities and equity
Expected operating  income (EBIT)
Less:  Interest (@ 12%)
Earnings before tax
Less:  Income tax @ 40%
Earnings after tax
Return on equity
Effect of a 20% Decrease in EBIT to $2,000,000
Expected operating  income (EBIT)
Less:  Interest (@ 12%)
Earnings before tax
Less:  Income tax @ 40%
Earnings after tax
Return on equity
Effect of a 20% Increase in EBIT to $3,000,000
Expected operating  income (EBIT)
Less:  Interest (@ 12%)
Earnings before tax
Less:  Income tax @ 40%
Earnings after tax
Return on equity

1. Which leverage ratio yields the highest expected return on equity?
2. Which leverage ratio yields the highest variability (risk) in expected return on equity?
3. What assumptions was made about the cost of debt (that is, the interest rates) under the various capital structures (that is, the leverage ratio)? How realistic is the assumption?

 

Question 2:      Washington paper company has estimated the costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure as follows. Determine the company’s optimal capital structure.

 

Tax rate	40%
Deb ratio	Pretax Cost	Cost of		After-tax Cost	Cost of
B / (B+E)	of debt	Equity		of debt	Equity	WACC
0	—	14.00%		??	??	??
0.1	7.00%	14.20%		??	??	??
0.2	7.20%	14.60%		??	??	??
0.3	7.60%	15.40%		??	??	??
0.4	8.20%	17.00%		??	??	??
0.5	9.00%	20.00%		??	??	??
0.6	10.00%	26.00%		??	??	??

 

Question 3:

Comment on how leverage could affect shareholder wealth and the cost of capital?

 

Question 4.

Wolverine Corporation plans to pay $3 dividend per share on each of its 300,000 shares next year. Wolverine anticipates earnings of $6.25 per share over the years. If the company has a capital budgeting requiring an investment of 4 million over the year, and it desires to maintain its present debt to total assets (debt ratio) of 0.40, how much external equity must it raise? Assume that Wolverine’s capital structure includes only common equity and debt, and that debt and equity will be the only sources of funds to finance capital projects over the year.

 

Hint:

(Retained earnings + New equity) + (New debt) = 4,000,000

Retained earnings = Earnings – Dividend = ??

Net debt / 4000000 = 0.4

Net debt = ??

Retained earnings + Net equity = 4000000 – New debt = ??

New equity = ??