There are two very similar companies (Company A and Company B), both with an ear

Question

There are two very similar companies (Company A and Company B), both with an earnings before interest and tax (EBIT) of £600k. The total capital employed by these two companies is £5m:Company A is funded entirely by equity (all £5m) and has no debt on its balance sheet.Company B is funded by £3m of equity and £2m of debt, with an interest rate of 7% per year.The corporate tax rate is 25%.

a) Calculate the interest paid to debtholders and the money left for shareholders after tax

(both in £) for the two companies separately.

b) Calculate the % return to shareholders under the two scenarios.

c) Do the owners of the company benefit from employing debt in this case? Does this

always hold?

Explanation / Answer

Solution :- Calculations:- Partculars Company A (amount in £) Company B (amount in £) EBIT 600,000 600,000 Less : interst (2,000,000*7%) 0 140000 EBT 600,000 460,000 Less:-Tax @25% 150000 115000 EAT 450,000 345,000 a) Company A Company B Interst paid Nil £140,000 Money left to shareholder after taX £450,000 £345,000 b) Percentage return to shareholders =EAT/Equity =450,000/5,000,000 =345,000/3,000,000 =9% =11.5% c) Yes the owners of company "B" are benefitted from employing debt, since the percentage return to shareholder is greater than company "A".This dose not always hold because , if the firm is earning less and interest rate is high it will affect adversly resulting in negative effect. Please feel free to ask if you have any query in the comment section.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.