An industrial firm with assets of $100 million is exploring the benefit of leveraging the balance sheet given expectations of economic growth. Currently, the firm is earning a return on assets of 9.00%, a return on equity of 15.00%, retains a debt ratio of 40% (equity to assets of 60%). The board of directors has requested management consider changing the debt ratio to 60% (equity to assets of 40%). The new debt will cost 4.00% given a credit rating downgrade. The firm will apply the proceeds of new debt to repurchase stock at book value. The firm is taxed @ 20% but expects that rate to rise in the future. First, estimate how the change in capital structure will impact pro forma net income, return on assets, and return on equity. Second, briefly indicate the advantages and risks of relying on additional debt to leverage the balance sheet.

Given: Total Assets = $100 million Return on Assets (ROA) = 9% Return on Equity (ROE) 15% Debt…

Answered: An industrial firm with assets of $100…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter11: Capital Budgeting And Risk

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Problem 25P

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An industrial firm with assets of $100 million is exploring the benefit of leveraging the balance sheet given expectations of economic growth. Currently, the firm is earning a return on assets of 9.00%, a return on equity of 15.00%, retains a debt ratio of 40% (equity to assets of 60%). The board of directors has requested management consider changing the debt ratio to 60% (equity to assets of 40%). The new debt will cost 4.00% given a credit rating downgrade. The firm will apply the proceeds of new debt to repurchase stock at book value. The firm is taxed @ 20% but expects that rate to rise in the future. First, estimate how the change in capital structure will impact pro forma net income, return on assets, and return on equity. Second, briefly indicate the advantages and risks of relying on additional debt to leverage the balance sheet.

Definition Definition Financial statement that provides a snapshot of an organization's financial position at a specific point in time. It summarizes a company's assets, liabilities, and shareholder's equity, detailing what the company owns, what it owes, and what is left over for its owners. The balance sheet serves as a crucial tool to assess the financial health and stability of a company, as well as to help management make informed decisions about its future investments and financial obligations.

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