Tut11q - Strictly for course AB102(2009 internal...

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Sept 13, 2009 Strictly for course AB102 (2009) internal circulation only. Nanyang Business School AB102 Financial Management Tutorial 11: Capital Structure and Leverage (Common Questions) 1) (14-5) Financial leverage effects . The firms HL and LL are identical except for their leverage ratios and interest rates on debt. Each has $20 million in assets, earned $4 million of EBIT, and is in the 40 percent federal-plus-state tax bracket. Firm HL, however, has a debt ratio (D/A) of 50 percent and pays 12 percent interest on its debt, whereas LL has 30 percent debt ratio and pays only 10 percent interest on its debt. a) Calculate the rate of return on equity (ROE) for each firm. b) Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt ratio from 30 to 60 percent, even though that would increase LL’s interest rate on all debt to 15 percent. Calculate the new ROE for LL. 2) (14-11) Recapitalization . Currently, Bloom Flowers Inc. has a capital structure consisting of 20 percent debt and 80 percent equity. Bloom’s debt currently has an 8 percent yield to maturity. The risk-free rate (r RF ) is 5 percent, and the market risk premium (r M – r RF ) is 6 percent. Using the CAPM, Bloom estimates that its cost of equity is currently 12.5 percent. The company has a 40 percent tax rate.
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