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Question - AgroChem expects a profitability of 10% measured by the return on investment (ROI). Further an operative cash flow (FFO) as of 20 mln EUR was disclosed for 2020. In addition the revenue profitability measured as earnings before interest and taxes (EBIT) to revenues was 5% in 2020. Agrochem is a fully equity funded company. This base scenario (scenario 1) is critically reflected by the management. They consider to increase the shareholder value of the company by the inclusion of debt. Scenario 2 is considered as an alternative. In this case the debt-equity ratio is set to 3 with an interest rate as of 9% for debt.
Required -
a) Calculate the return on equity ROE for both scenarios.
b) Calculate the absolute amounts of debt and equity as well as the equity ratio as equity in relation to total capital.
c) Do you think that the alternative scenario is in line with the basic risk of its business?
Explain how each of the events would affect the accounting equation by writing the letter I for increase, the letter D for decrease, and NA for does not affect under each of the components of the accounting equation.
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