Question 10 (10 points) A firm with a return on common equity (ROCE) of 30% has
ID: 2608346 • Letter: Q
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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. What rate of return does this firm earn on its operations? The firm is considering repurchasing $150 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? (a) (b)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
ROCE = 23.18% + 0.796 [23.18% - 5.0%] = 37.65%
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