Concept explainers
ROE and Leverage Suppose the company in Problem 1 has a market-to-book ratio of 1.0.
- a. Calculate
return on equity , ROE, und.er each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes. - b. Repeat part (a) assuming the firm goes through with the proposed recapitalization.
- c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent
a)
To determine: The return on equity and change in return on equity for the given scenario.
Introduction:
Return on equity is the evaluation of profitability that calculates how many amounts of profits the firm generates with each dollar of shareholder’s equity. The return on equity is computed by dividing the net income to the number of shareholders.
Explanation of Solution
Calculate the return on equity:
The market-to-book ratio is 1.0. The company’s total equity is equal to the market value of equity. The market value of company is $295,000.
The net income of the recession is $13,800, normal is $23,000 and for expansion it is $28,750.
Recession:
Therefore, the return on equity for recession is 4.68%.
Normal:
Therefore, the return on equity for normal is 7.79%.
Expansion:
Therefore, the return on equity for expansion is 9.75%.
Calculate percentage change in the return on equity:
Recession:
Therefore, the percentage change in ROE is 40%.
Normal:
Therefore, the percentage change in return on equity is 0%.
Expansion:
Therefore, the percentage change in return on equity is 25%.
b)
To determine: The return on equity and change in the percentage of equity.
Explanation of Solution
If the company carries out a proposed recapitalization, the new equity value is
calculated as follows.
Calculate the equity:
It is given that the debt issued value is $85,000.
Therefore, the total equity value is $206,500.
Calculate the return on equity:
Recession:
The net income of the company is $6,720 and the total equity value is $206,500.
Therefore, the return on equity value is 3.25%.
Normal:
The net income of the company is $15,920 and the total equity value is $206,500.
Therefore, the return on equity value is 7.70%.
Expansion:
The net income of the company is $21,670 and the total equity value is $206,500.
Therefore, the return on equity value is 10.49%.
Calculate percentage change in the return on equity:
Recession:
Therefore, the percentage change in return of equity value is 57.79%.
Normal:
Therefore, the percentage change in return of equity value is 0%.
Expansion:
Therefore, the percentage change in return of equity value is 36.05%.
c)
To determine: The return on equity and change in return on equity for the given scenario.
Explanation of Solution
If there are corporate taxes and the firm maintains its current capital structure, the return on equity is.
Determine the return on equity:
Recession:
The net income value is $8,970 and total equity value is $295,000.
Therefore, the return on equity is 3.04%.
Normal:
The net income value is $14,950 and total equity value is $295,000.
Therefore, the return on equity is 5.07%.
Expansion:
The net income value is $18,688 and total equity value is $295,000.
Therefore, the return on equity is 6.33%.
Calculate percentage change in the return on equity:
Recession:
Therefore, the percentage change in return of equity value is 40.00%.
Normal:
Therefore, the percentage change in return of equity value is 0%.
Expansion:
Therefore, the percentage change in return of equity value is 25%.
Calculate the return on equity with debts:
Recession:
The net income value is $4,368 and total equity value is $206,500.
Therefore, the return on equity is 2.12%.
Normal:
The net income value is $10,348 and total equity value is $206,500.
Therefore, the return on equity is 5.01%.
Expansion:
The net income value is $14,086 and total equity value is $206,500.
Therefore, the return on equity is 6.82%.
Calculate percentage change in the return on equity:
Recession:
Therefore, the percentage change in return of equity value is 57.58%.
Normal:
Therefore, the percentage change in return of equity value is 0%.
Expansion:
Therefore, the percentage change in return of equity value is 36.12%,
Want to see more full solutions like this?
Chapter 16 Solutions
CORPORATE FINANCE(LL)
- CONCEPTUAL: RETURN ON EQUITY Which of the following statements is most correct? (Hint: Work Problem 4-16 before answering 4-17, and consider the solution setup for 4-16 as you think about 4-17.) a. If a firms expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, adding assets and financing them with debt will raise the firms expected return on common equity (ROE). b. The higher a firms tax rate, the lower its BEP ratio, other things held constant. c. The higher the interest rate on a firms debt, the lower its BEP ratio, other things held constant. d. The higher a firms debt ratio, the lower its BEP ratio, other things held constant. e. Statement a is false, but statements b, c, and d are true.arrow_forwardNext, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firms various bond issues. A longer-term issues YTM could provide an estimate of the firms current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?arrow_forwardQuantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 6.5% yield to maturity. The risk-free rate (rRF) is 4.5%, and the market risk premium (rM – rRF) is 5.5%. Using the CAPM, MME estimates that its cost of equity is currently 12.6%. The company has a 40% tax rate. a. What is MME's current WACC? Do not round intermediate calculations. Round your answer to two decimal places. % b. What is the current beta on MME's common stock? Do not round intermediate calculations. Round your answer to four decimal places. c. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, bU?) Do not round intermediate calculations. Round your answer to four decimal places. MME's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the…arrow_forward
- You have the following initial information on which to base your calculations and discussion: Debt yield = 2.5% Required Rate of Return on Equity = 13% Expected return on S&P500 = 8% Risk-free rate (rF) = 1.5% Inflation = 2.5% Corporate tax rate (TC) = 30% Current long-term and target debt-equity ratio (D:E) = 1:3 a. What is the unlevered cost of equity (rE*) for this firm? Assume that the management of the firm is considering a leveraged buyout of the above company. They believe that they can gear the company to a higher level due to their ability to extract efficiencies from the firm’s operations. Thus, they wish to use a target debt-equity ratio of 3:1 in their valuation calculations.arrow_forwardYou have the following initial information on which to base your calculations and discussion: Debt yield = 2.5% Required Rate of Return on Equity = 13% Expected return on S&P500 = 8% Risk-free rate (rF) = 1.5% Inflation = 2.5% Corporate tax rate (TC) = 30% Current long-term and target debt-equity ratio (D:E) = 1:3 a. What is the unlevered cost of equity (rE*) for this firm? Assume that the management of the firm is considering a leveraged buyout of the above company. They believe that they can gear the company to a higher level due to their ability to extract efficiencies from the firm’s operations. Thus, they wish to use a target debt-equity ratio of 3:1 in their valuation calculations. b. What would the levered cost of equity equal for this firm at a debt-equity ratio (D:E) of 3:1? c. What would the required rate of return for the company equal if it were to be acquired under the leveraged buyout structure (i.e., what would the estimated firm WACC equal to under a…arrow_forwardA firm wants to strengthen its financial position. Which of the following actions would increase its current ratio? 1. b. Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. 2. d. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. 3. e. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash. 4. a. Use cash to increase inventory holdings. 5. c. Use cash to repurchase some of the company's own stock.arrow_forward
- The cost of retained earnings True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. True False The cost of equity using the CAPM approach The current risk-free rate of return (rRF ) is 4.23% while the market risk premium is 6.17%. The D’Amico Company has a beta of 1.56. Using the capital asset pricing model (CAPM) approach, D’Amico’s cost of equity is . The cost of equity using the bond yield plus risk premium approach The Kennedy Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company’s cost of internal equity. Kennedy’s bonds yield 10.28%, and the firm’s analysts estimate that the firm’s risk premium on its stock over its bonds is 5.89. Based on the bond-yield-plus-risk-premium approach, Kennedy’s cost of internal equity is:…arrow_forward(Liquidity analysis) Airspot Motors, Inc. has $2,172,500 in current assets and $869,000 in current liabilities. The company's managers want to increase the firm's inventory, which will be financed using short-term debt. How much can the firm increase its inventory without its current ratio falling below 2.1 (assuming all other current assets and current liabilities remain constant)?arrow_forwardA firm has been experiencing low profitability in recent years. Performan analysis of the firm’s financial position using the DuPont equation. The firm has no leasepayments but has a $2 million sinking fund payment on its debt. The most recent industryaverage ratios and the firm’s financial statements are as follows: a. Calculate the ratios you think would be useful in this analysis.b. Construct a DuPont equation, and compare the company’s ratios to the industry averageratios.c. Do the balance sheet accounts or the income statement figures seem to be primarilyresponsible for the low profits?d. Which specific accounts seem to be most out of line relative to other firms in the industry?e. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during theyear, how might that affect the validity of your ratio analysis? How might you correctfor such potential problems?arrow_forward
- Suppose Goodyear Tire and Rubber Company has an equity cost of capital of 8.6%, a debt cost of capital of 7.1%, a marginal corporate tax rate of 24%, and a debt-equity ratio of 2.5. Assume that Goodyear maintains a constant debt-equity ratio. a. What is Goodyear's WACC? b. What is Goodyear's unlevered cost of capital? c. Explain, intuitively, why Goodyear's unlevered cost of capital is less than its equity cost of capital and higher than its WACC. Question content area bottom Part 1 a. What is Goodyear's WACC? The WACC is enter your response here%. (Round to two decimal places.)arrow_forwardGive typing answer with explanation and conclusion A firm currently has a debt-equity ratio of 2/5. The debt, which is virtually riskless, pays an interest rate of 4 %. The expected rate of return on the equity is 13 %. What is the Weighted-Average Cost of Capital if the firm pays no taxes? Enter your answer as a percentage rounded to two decimal places. Do not include the percentage sign in your answer.arrow_forwardYou have the following initial information on Financeur Co. on which to base your calculations and discussion for question 2): • Current long-term and target debt-equity ratio (D:E) = 1:3 • Corporate tax rate (TC) = 30% • Expected Inflation = 1.55% • Equity beta (E) = 1.6325 • Debt beta (D) = 0.203 • Expected market premium (rM – rF) = 6.00% • Risk-free rate (rF) =2.05% 2) Assume now a firm that is an existing customer of Financeur Co. is considering a buyout of Financeur Co. to allow them to integrate production activities. The potential acquiring firm’s management has approached an investment bank for advice. The bank believes that the firm can gear Financeur Co. to a higher level, given that its existing management has been highly conservative in its use of debt. It also notes that the customer’s firm has the same cost of debt as that of Financeur Co. Thus, it has suggested use of a target debtequity ratio of 2:3 when undertaking valuation calculations. a) What would the required…arrow_forward
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning
- Fundamentals Of Financial Management, Concise Edi...FinanceISBN:9781337902571Author:Eugene F. Brigham, Joel F. HoustonPublisher:Cengage LearningCornerstones of Cost Management (Cornerstones Ser...AccountingISBN:9781305970663Author:Don R. Hansen, Maryanne M. MowenPublisher:Cengage LearningSurvey of Accounting (Accounting I)AccountingISBN:9781305961883Author:Carl WarrenPublisher:Cengage Learning