Ace Enterprises Limited is a large company involved in production and sale of petroleum products. The Finance Department of the company is trying to determine the company’s optimal capital structure. The firms’ financial advisors have developed the following table: Equity Ratio Debt Ratio Before Tax Cost of Debt 100% 0% 7% 80% 20% 8% 60% 40% 10% 40% 60% 12% 20% 80% 15% The company uses and applies the Capital Assets Pricing Model to estimate its cost of common equity. The company estimates that the risk free rate is 4.0%. The market risk premium is 6.0%, and its tax rate is 30 percent. The company estimates that if it had no debt, its unlevered beta would be 1.2. Required: A. Based on the above information, what is the firm’s optimal capital structure? B. What would the weighted average cost of capital be at the optimal capital structure? C. If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline? (Please show all of your computations and tabulations)
Reporting Cash Flows
Reporting of cash flows means a statement of cash flow which is a financial statement. A cash flow statement is prepared by gathering all the data regarding inflows and outflows of a company. The cash flow statement includes cash inflows and outflows from various activities such as operating, financing, and investment. Reporting this statement is important because it is the main financial statement of the company.
Balance Sheet
A balance sheet is an integral part of the set of financial statements of an organization that reports the assets, liabilities, equity (shareholding) capital, other short and long-term debts, along with other related items. A balance sheet is one of the most critical measures of the financial performance and position of the company, and as the name suggests, the statement must balance the assets against the liabilities and equity. The assets are what the company owns, and the liabilities represent what the company owes. Equity represents the amount invested in the business, either by the promoters of the company or by external shareholders. The total assets must match total liabilities plus equity.
Financial Statements
Financial statements are written records of an organization which provide a true and real picture of business activities. It shows the financial position and the operating performance of the company. It is prepared at the end of every financial cycle. It includes three main components that are balance sheet, income statement and cash flow statement.
Owner's Capital
Before we begin to understand what Owner’s capital is and what Equity financing is to an organization, it is important to understand some basic accounting terminologies. A double-entry bookkeeping system Normal account balances are those which are expected to have either a debit balance or a credit balance, depending on the nature of the account. An asset account will have a debit balance as normal balance because an asset is a debit account. Similarly, a liability account will have the normal balance as a credit balance because it is amount owed, representing a credit account. Equity is also said to have a credit balance as its normal balance. However, sometimes the normal balances may be reversed, often due to incorrect journal or posting entries or other accounting/ clerical errors.
Ace Enterprises Limited is a large company involved in production and sale of petroleum products. The Finance Department of the company is trying to determine the company’s optimal capital structure. The firms’ financial advisors have developed the following table:
| Equity Ratio | Debt Ratio | Before Tax Cost of Debt |
| 100% | 0% | 7% |
| 80% | 20% | 8% |
| 60% | 40% | 10% |
| 40% | 60% | 12% |
| 20% | 80% | 15% |
The company uses and applies the
Required:
A. Based on the above information, what is the firm’s optimal capital structure?
B. What would the weighted average cost of capital be at the optimal capital structure?
C. If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline? (Please show all of your computations and tabulations)
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