Question 14 (30 points) Niglow Corporation produces metal castings. In the past

Question

Question 14 (30 points) Niglow Corporation produces metal castings. In the past year it earned a 10% return on its net operating assets base of S10M. Niglow needs $10M to expand its operations, and has the option of obtaining none, some, or all of the proceeds from the bank. Currently the company is all equity financed. It expects to be able to maintain its return on net operating assets after the expansion. The bank has indicated that the amount it will charge on the loan will be dependent upon the resultant debt/equity ratio. Specifically, the rates will be 8%,9%, 10% and 12% for debt to equity ratios less than or equal to 0.25, 0.5, 1.0 and over 1.0, respectively. Niglow's tax rate is 40%. A. Calculate Niglow's return on common equity if the expansion is financed: i. using all equity ii, 50% debt, 50% equity ii. all debt B. What would Niglow's return on net operating assets need to be for the return on equityo be decreased by financing the expansion using all debt.

Explanation / Answer

A. Return on Common Equity if Expansion is financed:

i. 100% Equity

Answer: If the expansion is s100% equity financed, then the Return on common equity would be Return on its Net Operating Asset Base of 10%.

ii. 50% Debt, and 50% Equity

Answer: First we need to find out the debt equity ratio

Debt equity ratio = 5/(10+5) = 1/3

Hence interest cost would be 9% (as per given in question)

Cost of interest = 9% * $5 Million = $0.45 Million

After Tax Interest Cost = 0.45 Million * (1-0.40) = o.45 M * 0.60 = $0.27 Million

If Return on Net Operating Asset (RNOA) = 10%

Which means income before interest (net of taxes) = $20 Million * 10% = $2Million

Net income will be $2Million - $0.27 Million = $1.73 Million

Return on Capital Employed = 1.73/15 * 100 = 11.53 %

iii. All debt financing:

With 100% debt financing, the debt equity ratio would be 1

Interest rate - 10%

Interest Cost = 10% * 10 Million = 1 Million

After tax interest cost = 1 Million * (1-t) = 1 Million * (1-0.4) = $ 0.6 Million

Net Income = $ 2 Million - $ 0.6 Million = $ 1.4 Million

ROCE = 1.4/10 * 100 = 14%

B. Niglow's return on Net Operating Assets to be for the return on equity to be decreased by financing the expansion using all debt.

Answer: By replacing equity with debt, will increase the after-tax cost of debt would be higher than Return on Net Operating Assets (RNOA).

100% Debt financing would have a cost of debt of 10% * (1-t) = 10% * (1-0.40) = 10% * 0.6 = 6%

Assuming NOPAT of 1.2 Million after expansion.

Debt Equity ratio would be 1

Interest cost = 10 M * 10% = 1 Million

After tax it would be 1 Million * (1-0.4) = 0.6 Million

There fore Net incomee will be 1.2 Million - 0.6 Million = 0.6 Million.

Thus ROCE = 0.6/10 = 6%

Hence if RNOA is 6%, and after tax cost of debt is 6%, RNOA remains same.

If it is less than 6%, ROCE decreases.

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