11. You work for the CEO of a new company that plans to manufacture and sell a n

Question

11. You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU?

                             0% Debt, U    60% Debt, L

Oper. income (EBIT) $400,000       $400,000

Required investment $2,500,000     $2,500,000

% Debt                                   0.0% 60.0%

$ of Debt                               $0.00 $1,500,000

$ of Common equity $2,500,000 $1,000,000

Interest rate                              NA 10.00%

Tax rate                                  35% 35%

A. 5.85%

B. 6.14%

C. 6.45%

D. 6.77%

E. 7.11%

12. What would not change during a capital restructuring process:
A. Shares outstanding
B. Fixed assets
C. Total equity
D. Total debt
E. Debt/equity ratio

14. Wayco Industrial Supply has an after tax cost of debt of 9.2 percent, a cost of equity of 14.3 percent, and a cost of preferred stock of 5.5 percent. The firm has 220,000 shares of common stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a market price of $1,012. The company's tax rate is 37 percent. What is the firm's weighted average cost of capital?

A. 9.18 percent

B. 10.24 percent

C. 11.02 percent

D. 12.73 percent

E. 13.54 percent

Explanation / Answer

11.

Correct answer is A. 5.85%

Working Analysis / Note:

Analysis for Unlevered firm (U)

Operating income (EBIT) =$400000

Debt = 0

So, Profit before tax = $400000

Tax Rate = 35%

So, Net income after tax = Profit before tax*(1-T) = 400000*(1-.35) = $260000

Equity Value = $2500000

ROE of Unlevered firm = Net income after tax / Equity value = 260000/2500000 = 10.4%

Analysis for levered firm (L)

Operating income (EBIT) =$400000

Debt value = $1500000 @ 10% interest

So, Profit Before Tax = Operating income (EBIT) - Debt value* interest rate

Profit Before Tax =400000 - 1500000*.10 = $250000

Net Profit after tax = Profit Before Tax*(1-T) = 250000*(1-.35) = $162500

ROE of Levered firm = Net Profit after tax / Equity value = 1625000 / 1000000 = 16.25%

ROEL - ROEU   = 16.25% - 10.4% = 5.85%

Thus, ROE for levered firm will increase by 5.85%

12.

Correct Answer is B. Fixed assets

Explanation:

In capital restructuring process, we restructure sources of finance such as debt and equity. Any change in debt or equity will also change the percentage composition as well as debt / equity ratio between them. But, it will not affect the fixed assets because they are not being restructured.

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