Question 10 10 points A firm with a return on common equity

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)

Solution

(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%