Question 10 (10 points) A firm with a return on common equity (ROCE) of 30% has

Question

Question 10 (10 points) A firm with a return on common equity (ROCE) of 30% has financial leverage of 37.5% and a net after-tax borrowing cost of 5% on S240 million of net debt. (a) (b) What rate of return does this firm earn on its operations? The firm is considering repurchasing S150 million of its stock and financing the repurchase with further borrowing at a 5% after-tax borrowing cost, what effect will this transaction have on the firm's return on common equity if the same level of operating profitability is maintained?

Explanation / Answer

(a)          ROCE = RNOA + FLEV [RNOA –NBC]

                30.0% = ? + 0.375 [? – 5.0%]

                ? = 23.18%

(b)          Financial leverage (FLEV before repurchases) =

                                                                                                                                                ? = 640

                Common equity after repurchase = 640 – 150 = 490

                Net debt after repurchase = 240 + 150 = 390

                Financial leverage after repurchase = 390/490 = 0.796

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