Question 14 30 points Niglow Corporation produces metal cast

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.

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

50% debt and 50% equity

debt equity ratio

5/(10+5)

0.333333

rate of interest if debt equity ratio is less than or equal to 50%

after tax cost of debt

9*(1-tax rate)

5.4

EBIT

20*10%

less interst on debt

5*5.4%

0.27

EBT

1.73

ROCE = EBT/capital employed

1.73/15

11.53%

All debt

100% debt financing

debt equity ratio

10-Oct

rate of interest if debt equity ratio is 1

10%

after tax cost of debt

10*(1-.4)

EBIT

20*10%

less interst on debt

10*6%

0.6

EBT

1.4

ROCE = EBT/capital employed

1.4/10

14%

B-

If return on equity is decreased by using all debt this means that the after tax cost of debtwould be higher than return on net operating assets. An all debt financed expansion has anafter 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

Lets assume return on net operating assets = 6% so EBIT after expansion =20*6% = 1.2and after tax cost of debt = 10*(1-tax rate) =10*(1-.4)= 6%

EBIT

20*6%

1.2

less interst on debt

10*6%

0.6

EBT

0.6

ROCE = EBT/capital employed

.6/10

Thus if RNOA is 6% and after-tax cost of debt is6%, the RNOA remains the same. If it is less than 6%, ROCE decreases

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

2-	50% debt and 50% equity
	debt equity ratio	5/(10+5)	0.333333
	rate of interest if debt equity ratio is less than or equal to 50%	9%
	after tax cost of debt	9*(1-tax rate)	5.4

	EBIT	20*10%	2
	less interst on debt	5*5.4%	0.27
	EBT		1.73
	ROCE = EBT/capital employed	1.73/15	11.53%

3-	All debt
	100% debt financing
	debt equity ratio	10-Oct	1
	rate of interest if debt equity ratio is 1	10%
	after tax cost of debt	10*(1-.4)	6

	EBIT	20*10%	2
	less interst on debt	10*6%	0.6
	EBT		1.4
	ROCE = EBT/capital employed	1.4/10	14%

B-	If return on equity is decreased by using all debt this means that the after tax cost of debtwould be higher than return on net operating assets. An all debt financed expansion has anafter 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
	Lets assume return on net operating assets = 6% so EBIT after expansion =206% = 1.2and after tax cost of debt = 10(1-tax rate) =10*(1-.4)= 6%
	EBIT	20*6%	1.2
	less interst on debt	10*6%	0.6
	EBT		0.6
	ROCE = EBT/capital employed	.6/10	6%

	Thus if RNOA is 6% and after-tax cost of debt is6%, the RNOA remains the same. If it is less than 6%, ROCE decreases

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 ne

Question 14 30 points Niglow Corporation produces metal cast

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