The impact of financial leverage on return on equity and earnings per share Consider the following case of Lost Pigeon Aviation: Suppose Lost Pigeon Aviation is considering a project that will require $200,000 in assets. • The project is expected to produce earnings before interest and taxes (EBIT) of $40,000. • Common equity outstanding will be 25,000 shares. • The company incurs a tax rate of 35%. If the project is financed using 100% equity capital, then Lost Pigeon Aviation's return on equity (ROE) on the project will be . In addition, Lost Pigeon's earnings per share (EPS) will be Alternatively, Lost Pigeon Aviation's CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company's debt will be 12%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. Lost Pigeon Aviation's ROE and the company's EPS will be if management decides to finance the project with 50% debt and 50% equity. When a firm uses debt financing, the business risk exposure for the firm's common shareholders will

The impact of financial leverage on return on equity and earnings per share Consider the following case of Lost Pigeon Aviation: Suppose Lost Pigeon Aviation is considering a project that will require $200,000 in assets. • The project is expected to produce earnings before interest and taxes (EBIT) of $40,000. • Common equity outstanding will be 25,000 shares. • The company incurs a tax rate of 35%. If the project is financed using 100% equity capital, then Lost Pigeon Aviation's return on equity (ROE) on the project will be . In addition, Lost Pigeon's earnings per share (EPS) will be Alternatively, Lost Pigeon Aviation's CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company's debt will be 12%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. Lost Pigeon Aviation's ROE and the company's EPS will be if management decides to finance the project with 50% debt and 50% equity. When a firm uses debt financing, the business risk exposure for the firm's common shareholders will

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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Shinedown Company needs to raise $40 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 55 percent common stock, 15 percent preferred stock, and 30 percent debt. Flotation costs for issuing new common stock are 6 percent, for new preferred stock, 3 percent, and for new debt, 1 percent. What is the true initial cost figure the company should use when evaluating its project? (Do not round intermediate calculations and enter your answer in dollars, not millions, rounded to the nearest whole number, e.g., 1,234,567.) Answer is complete but not entirely correct. Initial cost 418,848,168 X $
15. Sanitorium Brewing Company (SBC) must set its investment and dividend/repurchases policies for next year. It has 900,000 shares and its expected share price next year is $32.00. It can select from three independent projects, each of which will require a $3.5M investment. The projects have different risk levels, so SBC is appropriately evaluating them using different costs of capital. Assuming normal cashflows, the projected IRRS and costs of capital follow: Cost of Capital IRR 20% Project A: Project B: Project C: 17% 13% 10% 7% 9% SBC wants to maintain its 40% debt and 60% common equity capital structure, and it expects net income of $5.0M next year. If SBC also keeps its residual dividend policy (with all distributions as dividends, not share repurchases), what will its payout ratio be next year?
3
Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows of 51.54 million per year, growing at a rate of 2.4% per year. Goodyear has an equity cost of capital of 8,7%, a debt cost of capital of 6.7%, a marginal corporate tax rate of 38%, and a debt- equity ratio of 2.6. If the plant has average risk and Goodyear plans to maintain a constant debt equity ratio, what after tax amount must it receive for the plant for the divestiture to be profitable?
A firm has two independent projects, each requiring investment of INR 3 million, but each of these have different risk profiles, i.e., different costs of capital as below: Project A 17%, Project B 7% IRRs for A and B are 20% and 9% respectively. The firm would maintain a 30:70 debt-equity ratio and expects its net income to be 6 million INR. If this firms maintains a residual dividend policy (all cash distributed as dividends), what will be the pay-out ratio for this firm?
Suppose there are two alternatives to finance a power generation project planned by ABC (Pvt.) Ltd. Alternative A is to financing the total capital of Rs. 450 Mn with equity and Alternative B is to employ Rs.150 Mn equity, Rs. 100 Mn by 14% debentures and the rest by a 15% bank loan. The corporate tax rate is 30% and the owners expects 18% dividend in both alternatives. Earnings before interest and tax (EBIT) for the project is estimated as Rs.250 Mn. a. Calculate weighted average cost of capital (WACC) for both alternatives.
Suppose your company needs $17 million to build a new assembly line. Your target debt- equity ratio is .75. The flotation cost for new equity is 10 percent, but the flotation cost for debt is only 7 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small. a. What is your company's weighted average flotation cost, assuming all equity is raised externally? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What is the true cost of building the new assembly line after taking flotation costs into account? (Do not round intermediate calculations and enter your answer in dollars, not millions, rounded to the nearest whole dollar amount, e.g., 1,234,5667.) a. Flotation cost b. Amount raised %
Consider a firm with an EBITDA of $1,100,000 and an EBIT of $1,000,000. The firm finances its assets with $4,650,000 debt (costing 8.6 percent, all of which is tax deductible) and 216,000 shares of stock selling at $18 per share. To reduce risk associated with this financial leverage, the firm is considering reducing its debt by $2,700,000 by selling additional shares of stock. The firm's tax rate is 21 percent. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $1,000,000. Calculate the EPS before and after the change in capital structure and indicate changes in EPS. (Do not round intermediate calculations. Round your answers to 2 decimal places.) EPS before EPS after Changes in debt $ $ $ 2:19 1.80 0:40
hi, this is my finance question. i need answer asap.
Grey Manufacturing was considering a major expansion of its manufacturing operations. To raise the needed funds Grey's management has decided to simply use the firm's present capital structure as follows: • SOURCE OF CAPITAL AMOUNT OF RUND AFTER TAX COST OF RAISES CAPITAL Debt 80,000 5.20% Common stock 120,000 14.50% Total 200,000 What is your estimate Grey's WACC?
Olsen Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% debt, and its tax rate is 25%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $1 million of retained earnings with a cost of rs = 10%. New common stock in an amount up to $10 million would have a cost of re = 12.0%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of rd = 10% and an additional $4 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of $8.4 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places. %

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