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What is the expected return of equity in this scenario

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Reference no: EM132746106

Questions -

Q1. Hello Ltd is currently an all equity firm with an expected return of 12%. It is considering borrowing money to buy back some of its existing shares, thus, increasing its leverage.

Required -

a) Suppose Hello Ltd borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost of capital is 6%. What will be the expected return of equity be after the transaction?

b) Suppose Hello Ltd borrows to the point that debt-equity ratio is 1.50. At this point debt will be much riskier, therefore the cost of debt will be 8%. What is the expected return of equity in this scenario?

c) A senior Manager argues that it ios in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument?

Q2. Armstrong Ltd has $10 million in permanent debt outstanding. The firm will pay interest only on debt. The company's marginal tax is at 35% for the foreseeable future.

Required -

a) Suppose Armstrong pays interest of 6% per year on its debt, what is the annual interest tax shield?

b) What is the present value of the interest tax shield, assuming its risk is the same as the loan?

c) Suppose instead that the interest rate on the debt is 15%. What is the present value of the interest tax shield fro this case?

Q3. Summit Builders has a market debt-equity ratio of 0.65 and a corporate tax is 40%, and pays 7% interest on its debt.

By what amount does the interest tax shield from its debt will lower Summit's WACC? argument?

Reference no: EM132746106

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