Question 14 (30 points) Niglow Corporation produces metal castings. In the past

Question

Question 14 (30 points) Niglow Corporation produces metal castings. In the past year it earned a 10% return on its net operating assets base of S10M. Niglow needs S10M to expand its operations, and has the option of obtaining none, some, or all of the proceeds from the bank. Currently the company is all equity financed. It expects to be able to maintain its return on net operating assets after the expansion. The bank has indicated that the amount it will charge on the loan will be dependent upon the resultant debt/equity ratio. Specifically, the rates will be 8%,9%, 10% and 12% for debt to equity ratios less than or equal to 0.25, 0.5, 1.0 and over 1.0. respectively. Niglow's tax rate is 40%. A. Calculate Niglow's return on common equity if the expansion is financed: i. using all equity ii, 50% debt, 50% equity iii. all debt B. What would Niglow's return on net operating assets need to be for the return on equity to be decreased by financing the expansion using all debt.

Explanation / Answer

Solution:-

A.

i. Using all equity:-

If the expansion is all equity financed then ROCE will equal RNOA of 10%.

ii. 50% debt, 50% equity:-

50% debt and 50% equity means a resultant debt to equity ratio of 1/3 (5/10+5). This will result in an interest rate of 9%.

Interest costs will be 5Mx.09 = .45M.

After tax the interest costs will be .45*(1-.4) = 0.27M.

RNOA equals 10% which means net income before interest, net of tax is 20Mx.10 = 2M.

Therefore net income will be 2M- 0.27M = 1.73M. ROCE will be 11.53%

iii. all debt:-

All debt financed will result in a debt/equity ratio of 1. This will mean an interest rate of 10%.

Interest costs will be 10Mx .1 = 1M.

After tax, this will be 0.6M.

Therefore, net income will be 2M -0.6M = 1.4M. ROCE will be 14%.

B.

If return on equity is decreased by using all debt this means that the after tax cost of debt would be higher than return on net operating assets. An all debt financed expansion has an after tax cost of 6% (10 x (1-.4)). Therefore, if return on net operating assets was less than 6% this would result in a decrease in the return on equity.

Assume return on net operating assets is 6%, this implies NOPAT of 1.2M after expansion.

All debt financed will result in a debt/equity ratio of 1. This will mean an interest rate of 10%. Interest costs will be 10Mx .1 = 1M. After tax, this will be 0.6M. Therefore, net income will be 1.2M -0.6M = 6M. ROCE will be 6%. Thus if RNOA is 6% and after-tax cost of debt is 6%, the RNOA remains the same. If it is less than 6%, ROCE decreases.

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