Answer:
a. Calculate Niglow's return on common equity if the expansion is financed:
i. using all equity
since the company has no debts, equity = assets
return on equity = 10% = $20,000,000 x 10% = $2,000,000
ii, 50% debt, 50% equity
total debt $5 million, so after tax cost of debt = $5,000,000 x 9% x (1 - 40%) = $270,000
total return = $2,000,000 - $270,000 = $1,730,000
return on equity = $1,730,000 / $15,000,000 = 0.1153 = 11.53%
iii. all debt.
total debt $10 million, so after tax cost of debt = $10,000,000 x 10% x (1 - 40%) = $600,000
total return = $2,000,000 - $600,000 = $1,400,000
return on equity = $1,400,000 / $10,000,000 = 0.14= 14%
b. What would Niglow's return on net operating assets need to be for the return on equity to be decreased by financing the expansion using all debt.
total return = $999,999 or less
total return = operating return - $600,000
$999,999 + $600,000 = operating return
operating return = $1,599,999 or less
