Question 1
She can create departmental and overall budgets that can be used to monitor performance by ensuring costs are minimized and revenues are maximized.
.Question 2
Return on Equity = Net Income/Total shareholder Equity
Actual
ROE = 20,999/225,888 = 8.98%
10% Debt
ROE = 19,359/203,299 = 9.52%
20% Debt
ROE = 18,419/180,710 = 10.19%
30%
ROE = 17,480/158,122 = 11.05%
Debt in the capital structure enhances the returns on equity the company realizes. The computations above based on exhibit 9 reveal that the return on equity increases as the debt ratio increases. It can be explained by the fact that debt shield some of the income from taxes as interest paid on debt is a deductible expenses when determining the net income upon which taxes are composed.
βL = βU[1+(1-T)D/E].
Actual
βL = 0.85[1+(1-0.325)0] = 0.85
10% Debt
βL = 0.85[1+(1-0.325)0.11] = 1.03
20% Debt
βL = 0.85[1+(1-0.325)0.25] = 1.27
30% Debt
βL = 0.85[1+(1-0.325)0.43] = 1.58
Cost of Equity = Risk free rate + β*Risk Premium
The risk premium that is charged by the bank of America of 0.80% is the benchmark that was used.
Risk free rate = LIBOR = 5.36%
Market return = 5.36%
Actual
Return on equity = 5.36 + 0.85*0.80 = 6.04%
10 % Debt
Return on equity = 5.36 + 1.03*0.80 = 6.18%
20 % Debt
Return on equity = 5.36 + 1.27*0.80 = 6.38%
30% Debt
Return on equity = 5.36 + 1.58*0.80 = 6.62%
Question 3
Intrinsic Share Value = DPS/ Re
Assuming that the company paid out 50 percent of its 1.08 earnings per share as dividend
Actual
Share price = 0.54/6.04% = 8.99
10 % Debt
Share price = 0.54/6.18% = 8.71
20% Debt
Share price = 0.54/6.38% = 8.49
30 % Debt
Share price = 0.54/6.62% = 8.26
The intrinsic value of the shares is lower than the market price. The company can only repurchase at the market price of 22.10 dollars. Offering a price that is below the market price will result in no willing sellers as potential sellers will prefer to sell it at the market price if they are listed in the stock exchange market.
The shares will be purchased by the funds that are raised from debt financing. Therefore, the shares that will be purchased are given by
Shares purchased = Debt/ purchase price per share.
Actual
Shares purchased = 0/22.10 = 0
10% debt
Shares purchased = 22,589,000/22.10 = 0
20% debt
Shares purchased = 45,178,000/22.10 = 0
30% debt
Shares purchased = 67,766,000/22.10 = 0
Tax deductibility is the ability to deduct certain expenses fully or partially from the revenues before determining the amount on which tax will be imposed. Certain expenses are tax deductible while others are not tax deductible. Interest expense is one of the tax deductible expenses. Therefore, including debt on which interest is paid implies that the net income that is subjected to tax is reduced. The benefits of shielding part of the income from taxes increases with increase in the debt held by the company.
Question 4
My recommendation is that the capital structure of the company should include both debt as well as equity. Debt ensures that a significant portion of the net income is shielded from taxes thus reducing the taxes that are paid by the company. However, the debt should be moderate to ensure that the company is not highly geared. A high gearing ratio creates both liquidity as well as bankruptcy risks.
Works Cited
Khan, W. Financial Management: Text, Problems And Cases. New York: Tata McGraw-Hill Education, 2004. Print.
Shim, Jae and Joel Siegel. Financial Management. New. New York: Barron's Educational Series, 2008.
