CompanyX is an all equity financed company with an operating income of 9,000€ an

Question

CompanyX is an all equity financed company with an operating income of 9,000€ and
market value of assets of 50,000€. Assume that the company operates in perfect capital
markets with no corporate or personal taxes and M&M propositions I and II hold.

a) What is the return on assets of the company?
b) If the company decides to issue 15,000€ of debt and retire an equal amount of
equity, how will the rate of return for equity change? The beta of the company is
1.2 and the beta on its debt is 0.5. The expected return on its debt is 12%.
c) What is the new beta of the firm after the transaction described in b) ?
d) What is the beta of the equity after the transaction in b) ?

Explanation / Answer

A) ROA = Income/Assets = 9,000 / 50,000 = 0.18 or 18%, since all equity financed ROA=ROE B) ROE = Net income/Equity, equity = assets - liabilities (debt), Net income = operating income - interest on debt ROE = (9,000 - 15,000*0.12) / (50,000-15,000) = 7,200/35,000 = 0.2057 or 20.57% C) Under MM the WACC of the company will always stay the same no matter how financed from that follows that the overall beta will also stay the same: Therefore %debt*beta of debt + %equity * equity beta = firm beta (1.2 in this case) (15,000/50,000)*0.5 + (35,000/50,000)*X = 1.2 Solving for x we get X = (1.2 - (15,000/50,000*0.5))/(35,000/50,000) = 1.5 So debt beta = 0.5, equity beta = 1.5 weighted average beta = 1.2 (no change) D) see calculation above equity beta = 1.5 Hope this helps

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.