Finance

Running Head : FINANCE

Finance

Name

University

Lecturer

Course

Date

Divided yield

This is the expected dividend divided by the current price of as share of stock

D1 Dy (expected dividend yield on the stock during the coming year

Po

Where D1 dividend at year 1

Po current price

D1 2 .40 per share and Dy 8

Assume current price to be x

Dy D1

Po

8 2 .40

X

0 .08X 2 .40

X 2 .40 30 p

0 .08

Rate of return

This is the rate of return on a common stock that an individual stock holder expect to receive

Growth (g 4 indefinitely . This is a constant growth stock

Po 30

D1 3

Expected rate of return (Ks expected dividend yield plus expected growth rate or capital gains yield (Ks D1 g

Po 3 8 30 18

Stock price

Ks 16 .5 D1 3 Po (Assume x g 8

16 .5 3 g

x

0 .156x 3 0 .08x

x 3

0 .085 35 .30

Stock price 35 .30

WACC (weighted average cost of capital : reactive industries

Security market value ) required rate of return ) weight

Debt 20 6 25

stock 10 8 12 .5

Common stock 50 12 62 .5

Tax rate 35

Assumption

The required rate of return on debt 6 is the before tax cost of debt

Therefore after tax cost of capital kd (1-t 6 (1-35 3 .9

WACC WdKd (1-T WpKp WsKs 0 .25 (6 .65 0 .125 (8 0 .625 (12 0 .09475 9 .5

Earnings and leverage Reliable Gearing

10 ,000 shares 100 1 ,000 ,000

Low debt plan high debt plan

Debt 200 ,000 400 ,000

Equity 800 ,000 (8 ,000 shares 600 ,000 (6 ,000 shares

Debt to equity ratio 25 66 .67

Low debt ) high debt

EBIT 90 ,000 130 ,000 90 ,000 130 ,000

Less interest (10 (20 ,000 (20 ,000 (40 ,000 (40 ,000

Earnings before taxes (EBT ) 70 ,000 110 ,000 50 ,000 90 ,000

Taxes 0 0 0 0

Net income 70 ,000 110 ,000 50 ,000 90 ,000

Earnings per share (100 payout ) 8 .75 13 .75 8 .33 15

If both scenarios are equally likely 50 :50

EPS 8 .75 13 .75 8 .33 15 .00

2 2 11 .25 11 .67

Under the present interest rate of 10 , the high debt mix would be preferable . However in real world , if debt levels are high interest rate are also high

High leverage as good and bad effects : higher leverage increases expected earnings per share up to a certain points but also increases the firm 's risks (J . Fred Weston , Eugene F . Brigham ,1993

Low debt high debt

EBIT 100 ,000 100 ,000

LESS INTREST (10 (20 ,000 (40 ,000

80 ,000 60 ,000

EPS ) 80 ,000 10 60 ,000 10

8 ,000 6 ,000

EBIT of 100 ,000 is the break-even point of both the financing mixes hence EPS is the same

The break-even point sales revenue for each financing mix produces an...