Question 5: (Capital Structure) Firms R and S are similar firms in the same indu

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Question 5: (Capital Structure)

Firms R and S are similar firms in the same industry. Firms R and S have the same profit margin and total asset turnover when compared. However, Firm R's capital structure is 70% debt, 30% equity, and Firm S's capital structure is 30% debt, 70% equity. Given the above conditions, which firm will experience the highest return on equity (ROE)? Why?

Question 6: (Capital Structure)

A consultant has collected the following information regarding Hobbit Manufacturing:

Operating income (EBIT) $600 million, Debt $0, Interest expense $0, Tax rate 35%, Cost of equity 7%, WACC 7% . The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends . Hobbit can borrow money at a pre-tax rate of 5%. The consultant believes that if the company moves to a capital structure consisting of 30% debt and 70% equity (based on market values), which would require taking on debt in the amount of $1,779.47 million, that the cost of equity will increase to 8% and the pre-tax cost of debt will remain at 6%, but the value of the firm will rise. Is the consultant correct? If the company makes this change, what will be the increase in total market value for the firm?

Question 7: (Forecasting)

Jolly Joe's Novelties, Inc. had the financial data shown below last year. Jolly Joe's has just invented a new toy which they expect will cause sales to double from $100,000 to $180,000, increasing net income to $12,000. From experience the company knows that when sales changes, all current assets plus accounts payable and accrued expenses change at the same percentage rate, and the company feels they can handle the increase without adding any fixed assets.   

a. Will Jolly Joe's need any new outside funding if they pay no dividends?

             b. If so, how much will be needed?

Question 8: (Working Capital Management)

Suppose it takes Jolly Joe’s Novelties, Inc. 5 days to build and sell toys (on average). Also suppose it takes the firm’s customers 35 days, on average, to pay for the toys after they have purchased them on credit. Finally, suppose the firm is able to delay paying for the materials it uses in the manufacturing process for 30 days. Given these conditions, how long is Jolly Joe’s cash conversion cycle?

Question 9: (Working Capital Management)

If Jolly Joe’s buys $100 worth of supplies on credit with terms 3/10 n30 and pays the bill on the 28th day after the purchase:

   a. What is the approximate, or “nominal,” cost of trade credit as an annual rate?

   b. What is the exact cost of trade credit as an annual rate?

Historical Balance Sheet for Jolly Joe's Novelties, Inc ASSETS Current Assets LIABILITIES AND EQUITY Current Liabilities $3,500 $1,500 $8,000 Accounts payable Cash Accounts Receivable $4,500 Accrued Expenses Inventory $9.500 Notes Payable $25,000 $265.000 $290,000 $32,000 $40,000 $72.000 TOTAL LABILITIES AND EQUITY $362.000 S22,000 Total Current Liabilities Total Current Assets Fixed Assets TOTAL ASSETS $340.000 Mortgage $362000 Total Liabilities Common Stock Retained Earnings Total Equity

Explanation / Answer

Ans 5 ROE= Net Income/ Shareholder Equity

ROE can further be decomposed i.e. DuPont Decomposition

ROE = profit margin X asset turnover X gearing
ROE = (profit for the year ÷ sales) X (sales ÷ assets) X (assets ÷ shareholders’ equity)

Gearing ratio (for example debt to equity ratio) tells that assets are financied either by shareholder or by creditors, a higher ratio means than firm is being financed more by debt. So theoritically greater gearing increases ROE.So a high level of debt can artificially boost ROE because the more debt a company has, the less shareholders' equity it has (as a percentage of total assets), and the higher its ROE is.

So firm R with 70% debt and 30% equity will experience highest ROE as gearing ratio will be more which in yurn increases the ROE.

Dear user please post one question at a time not multiple.

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