No-Toxic-Toys currently has $200,000 of equity and is planning an $80,000 expansion to meet increasing demand for its product. The company currently earns $50,000 in net income, and the expansion will yield $25,000 in additional income before any interest expense. The company has three options: (1) do not expand, (2) expand and issue $80,000 in debt that requires payments of 8% annual interest, or (3) expand and raise $80,000 from equity financing. For each option, compute (a) net income and (b) return on equity (Net income ÷ Equity). Ignore any income tax effects.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
No-Toxic-Toys currently has $200,000 of equity and is planning an $80,000 expansion to meet increasing
demand for its product. The company currently earns $50,000 in net income, and the expansion will yield
$25,000 in additional income before any interest expense.
The company has three options: (1) do not expand, (2) expand and issue $80,000 in debt that requires
payments of 8% annual interest, or (3) expand and raise $80,000 from equity financing. For each option,
compute (a) net income and (b) return on equity (Net income ÷ Equity). Ignore any income tax effects.
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