Capital Structure and Leverage - Solutions11

# Capital Structure and Leverage - Solutions11 - ROA =...

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 56 of 59 Pages ROA = 12.0% (Given) r P = 10.0% (Given) Preferred Dividend = (\$1,000,000)*(.10) = \$100,000 Preferred stock does not create a tax shelter, so ROE = ROA (unlevered) + Leverage Effect ROE = 0.12 + (0.12 - 0.10)*(.25) ROE = 0.12 + 0.005 = 12.50% Alternatively, ROA = NI / TA NI = (ROA)*(TA) = (0.12)*(\$5,000,000) = \$600,000 Work backwards up through income statement to get EBIT: EBIT \$1,000,000 Interest -\$ 0 EBT \$1,000,000 Taxes -\$ 400,000 Net Income \$ 600,000 Preferred Dividend \$ 0 Available to Common \$ 600,000 Now consider the preferred stock dividend payment: Dividend = (\$1,000,000)*(0.10) = \$100,000 EBIT \$1,000,000 Interest -\$ 0 EBT \$1,000,000 Taxes -\$ 400,000 Net Income \$ 600,000 Preferred Dividend -\$ 100,000 Available to Common \$ 500,000 NEW ROE = \$500,000 / \$4,000,000 = 12.50% 58. Assume that the risk-free rate is 4.00 percent, the return on the market is 8.00 percent, the tax rate is 40 percent, and that a firm’s cost of stock, using the CAPM/SML, is 8.80 percent [HINT: you should now be able to determine the firm’s levered beta.] Also assume that the firm’s unlevered beta has a value of 1.00 [HINT: you should now be able to use the Hamada equations to back out the firm’s current debt/equity ratio.] Assuming that the firm now triples its debt/equity ratio, and using the Hamada equations to relever the firm’s beta, determine what the firm’s new cost of stock will be.

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 57 of 59 Pages A. 10.80% B. 10.00% C. 9.20% * D. 10.40% E. 9.60%
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