(a) (i)
WACC= E/V × Re+ D/V × Rd × (1-TC)
*Re = Cost of Equity = 16.65%
Rd = Cost of Debt = 7.00%
E/V=Percentage of financing that is equity= 100/130
D/V=Percentage of financing that is debt= 30/130
TC = Corporate tax rate = 0.25 = 25%
WACC= 100/130 × 16.65%+ D30/130 × 7.00% × (1-0.25)
Cost of Capital = 14.02% - 2.5%
= 11.52%
*Re = 3% + 2.1 (6.5%)
= 16.65%
(a) (ii)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Unit Sales (A) 2,000 3,500 4,200 5,000 5,100
Revenues (B) 17,000,000 29,750,000 35,700,000 42,500,000 43,350,000
Production cost (3,400,000) (5,950,000) (7,140,000) (8,500,000) (8,670,000)
Direct Marketing Expenses (1,700,000) (2,975,000) (3,570,000) (4,250,000) (4,335,000)
Depreciation (10,000,000) (10,000,000) (10,000,000) (10,000,000) (10,000,000)
Earning before Tax 1,900,000 10,825,000 14,990,000 19,750,000 20,345,000
Tax @ 25% (475,000) (2,706,250) (3,747,500) (4,937,500) (5,086,250)
Profit after tax 1,425,000 8,118,750 11,242,500 14,812,500 15,258,750
Add: Depreciation 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000
Cash flow-operation 11,425,000 18,118,750 21,242,500 24,812,500 25,258,750
Working Capital @ 12% 2,040,000 3,570,000 4,284,000 5,100,000 5,202,000 0
Increase in Working Capital (2,040,000) (1,530,000) (714,000) (816,000) (102,000) 5,202,000
Initial investment of plant (50,000,000) 8,000,000
Tax on gain @ 25% (2,000,000)
Net Cash Flow (52,040,000) 9,895,000 17,404,750 20,426,500 24,710,500 36,460,750
Discount factor @12% 1.0000 0.8967 0.8041 0.721 0.6465 0.5797
Present Value (52,040,000) 8,872,846.50 13,995,159.48 14,727,506.50 15,975,338.25 21,136,296.78
Net present value 22,667,148
Since the...
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These ratios can be used to determine the most desirable company to grant a loan to between Wendy’s and Bob Evans. Wendy’s has a debt to assets ratio of 34.93% while Bob Evans is 43.68%. When it comes to debt to asset ratios, the company with the lower percentage has the lowest risk. Therefore, Wendy’s is more desirable than Bob Evans. In the area of debt to equity ratios, Wendy’s comes in at 84.31% while Bob Evans comes in at 118.71%. Like debt to assets, a low debt to equity ratio indicates less risk in a company. Again, Wendy’s is the less risky company. Finally, Wendy’s has a times interest earned ratio of 4.86 while Bob Evans owns a 3.78. Unlike the previous two ratios, times interest earned ratio is measured on a scale of 1 to 5. The closer the ratio is to 5, the less risky a company is. From the view of a banker, any ratio over 2.5 is an acceptable risk. Both companies are an acceptable risk, however, Wendy’s is once again more desirable. Based on these findings, Wendy’s is the better choice for banks to loan money to because of the lower level of
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Another observation is that GM looks to use more debt financing that equity financing for funding their activities. The debt to equity ratio has steadily decreased over the past five years and is higher that the industry average. Also, the current and quick ratios are much lower than the industry averages. This again can pose so...
The consistent high spending of capital equipment is the first reason why one would recommend reducing the debt to equity ratio. A company with higher levels of debt is less flexible in being able to adjust to new market demands and conditions that require the company to make new products or respond to competition. Looking at the pecking order of financing, issuing new shares to fund capital investing is the last resort and a company that has high levels of debt, must move to the equity side to avoid the risk of bankruptcy. Defaulting on loans occur when increased costs or bad economic conditions lead the firm to have lower net income than the payments on loans. The risk of defaulting on loans and the direct and indirect cost related to defaulting lead firms to prefer lower levels of debt. The financial distress caused by additional leverage can lead to lower cash flows available to all investors, lower than if the firm was financed by equity only. Additionally, the high debt ratio that Du Pont incurred also led to them dropping from a AAA bond rating to a AA bond Rating. Although the likelihood of not being able to acquire loans would be minimal, there are increased interest costs with having a lower bond rating. The lower bond rating signals to investors that the firm is more likely to default than if it had a higher (AAA) bond rating.
There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an optimal capital structure by using a mixture debt and equity known to act as an advantage leverage. Modigliani and Miller (1958) showed that the decisions firms make when choosing between debt and equity financing has no material effects on the value of the firm or on the cost or availability of capital. They assumed perfect and frictionless capital markets, in which financial innovation would quickly extinguish any deviation from their predicted equilibrium.
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The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
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