Question

QUESTION 3: NoLev Limited an all equity firm has 1,000,000 shares of common stock outstanding at $50 per share. Janice Outperform wants to acquire a stake of 2% in NoLev but has not decided among the three possible financing choices. She can create homemade leverage by borrowing 40%, 50%, or 60% of the money she needs at a constant interest rate of 8% per year. The return on equity of NoLev is 15%. Assume an MM no tax world. a. How much dollar return Janice expects to earn from her investment each year under each of the three financing alternatives respectively? b. What are Janice’s returns on equity in each financing alternative respectively? c. What are Janice’s EPS in each financing alternative respectively? d. From parts (b) and (c), what inference can she draw about the return on equity and EPS of a leveraged firm?

Answer 1

Janice outperform wants to acquire a 2% stake of NoLev Ltd. Therefore, amount of funds required is 2% of $50,000,000 or $1,000,000.

a) Alternative 1: borrow 40% of money needed

Initial return on investment = 2% of NoLev's ROE which is 15%

Dollar return = 0.02(0.15 x 50,000,000) - 0.08(0.4 x 1,000,000)

= 150,000 - 32,000 = $118,000

Alternative 2: borrow 50% of money needed

Initial return on investment = 2% of NoLev's ROE which is 15%

Dollar return = 0.02(0.15 x 50,000,000) - 0.08(0.5 x 1,000,000) = $110,000

Alternative 3: borrow 60% of money needed

Initial return on investment = 2% of NoLev's ROE which is 15%

Dollar return = 0.02(0.15 x 50,000,000) - 0.08(0.6 x 1,000,000) = $102,000

b) Alternative 1:

40% debt capital used. Therefore 60% is equity capital

ROE = 118,000/600,000 = 19.66%

Alternative 2:

50% debt capital used. Therefore 50% is equity capital

ROE = 110,000/500,000 = 22%

Alternative 3:

60% debt capital used. Therefore 40% is equity capital

ROE = 102,000/400,000 = 25.5%

c) EPS under each alternative:

Alternative 1: Equity capital is $600,000. If we assume par value of Janice's shares as $10 then 60,000 shares have been issued. Therefore EPS = 118,000/60,000 = $1.97

Alternative 2: $500,000; 50,000 shares. EPS = 110,000/50,000 = $2.2

Alternative 3: $400,000; 40,000 shares. EPS = 102,000/40,000 = $2.55

d) The effect of leverage is positive on ROE and EPS. It can be seen that as the amount of leverage increases, the share of equity decreases and ROE and EPS increase. This makes debt a cheaper capital source than equity