Question

In: Finance

Please consider the following data for the Hercules Company: Assets:                  $3 billion Equity:          &nbs

Please consider the following data for the Hercules

Company:

Assets:                  $3 billion

Equity:                  $2 billion

Sales:                 $1.5 billion

EBIT:                  $300 million   

Profit (bt)           $200 million

Profit (at)           $150 million

Payout ratio is:       30%

Number of common stock shares outstanding is: 50 million shares

a) How much interest is Hercules paying on this debt?  

b What is Hercules Company’s current ROE & ROI (return on investment

      or return on assets)?   

c) i) If Hercules were to float (sell) $500 million in bonds and use the proceeds to buy back 12.5 million common shares back, what would be the new ROE & ROI?   Hint: What is the implied book/market price for a share of Hercules common stock? (Assume all else remains unchanged).

ii) If Hercules were to float (sell) $500 million in bonds and use the proceeds to buy new plant and equipment that would cause sales to increase to $2.5 billion with an increase in COGS of $800 million, what would be the new ROE & ROI? (Assume the tax rate & the interest 'rate' on debt remains unchanged.)

d)What are the sustainable growth rates for part b), c i) and c ii)?

b)                 c i)                  c ii) ____________

Solutions

Expert Solution

Part A)

Amount of interest expense = EBIT – profit before tax

                                                     = $300,000,000 - $200,000,000

                                                     = $100,000,000

Part B)

ROE = After tax profit / Equity

        = 150,000,000/ 2,000,000,000

        = 7.50%

ROI = After tax profit / assets

       = 150,000,000 / 3,000,000,000

       = 5%

Part C) i)

Price per share = 2,000,000,000 / 50,000,000

                              = $40

Common shares outstanding after restructuring = 50,000,000 -12,500,000

                                                                                          = 37,500,000

Interest rate = Amount of interest/ amount of debt

                        = 100,000,000 / 1,000,000,000

                        = 10%

New interest expense = total debt x interest rate

                                             = (1,000,000,000 +500,000,000) x 10%

                                             = 150,000,000

ROE = (EBIT – interest exp) x (1- tax rate)/ Equity

        = (300,000,000 – 150,000,000) x (1-25%)/ (37,500,000 x 40)

        = 150,000,000 x 0.75/ 1500,000,000

        = 7.50%

ROI = Net income/ Assets

       = 150,000,000 x0.75 / 3,000,000,000

       = 3.75%

Part Cii)

New interest expense = total debt x interest rate

                                             = (1,000,000,000 +500,000,000) x 10%

                                             = 150,000,000

New EBIT = $300,000,000 +2,500,000,000 -800,000,000

                   = 2,000,000,000

ROE= (EBIT – interest exp) x (1- tax rate)/ Equity

        = ( 2,000,000,000 – 150,000,000) x (1-0.25)/ 2,000,000,000

       = 69.375%

ROI = Net Income/ assets

       = 1387500000/ (3,000,000,000+500,000,000)

      = 39.64%


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