Homework answers / question archive / Currently the firm has a fixed total capital of $10, 000,000, which is made up of 20 percent debt and 80 percent equity

Currently the firm has a fixed total capital of $10, 000,000, which is made up of 20 percent debt and 80 percent equity

Finance

Share With

Currently the firm has a fixed total capital of $10, 000,000, which is made up of 20 percent debt and 80 percent equity. The firm has 100,000 outstanding ordinary shares and no preference shares. Although Theo feels that the firm’s current policy of paying out 60 percent of each year’s earnings in dividends is appropriate, he believes that the current capital structure may lack adequate financial leverage. In order to evaluate the firm’s capital structure, Theo is considering three alternative capital structures – A (30 percent debt ratio), B (50 percent debt ratio), and C (60 percent debt ratio). The interest rate on current debt is 10 percent and is believed to remain the same up to a borrowing limit of $1,000,000. Theo expects the firm’s current earnings before interest and taxes (EBIT) to remain at $1,200,000. The firm expects to have $200,000 of retained earnings available in the coming year. The firm has a tax rate of 40 percent. In assessing the cost of capital, Theo has the following information which has been compiled about the company’s current costs of two sources of capital: Exhibit 1 Source of capital Range of new financing Cost Long-term debt $0 to $1,000,000 10% $1,000,001 and above 11% Common stock equity $0 to $2,000,000 13% $2,000,001 and above 14% Retained earnings 12% 2 Exhibit 2 NAMIB MILLS Balance Sheet Assets 2017 2018 2019 Cash……………………………………………… $20,000 $30,000 $20,000 Marketable securities………………………… 30,000 35,000 50,000 Accounts receivable……………………………… 150,000 230,000 330,000 Inventory…………………………………… 250,000 285,000 325,000 Total Current Assets……………………………… 450,000 580,000 725,000 Net Plant and equipment…………………………… 550,000 720,000 1,169,000 Total Assets……………………………………….. $1,000,000 $1,300,000 $1,894,000 Liabilities & Equity Accounts payable……………………………. $100,000 $225,000 $200,000 Notes payable (bank)……………………………… 100,000 100,000 300,000 Total Current liabilities…………………………… 200,000 325,000 500,000 Long-term liabilities…………………………… 250,000 331,120 550,740 Total liabilities……………………………………… 450,000 656,120 1,050,740 Common stock ($10 par)…………………… 400,000 400,000 460,000 Capital paid in excess of par………………. 50,000 50,000 80,000 Retained earnings………………………………… 100,000 193,880 303,260 Total stockholders’ equity…………………………….. 550,000 643,880 843,260 Total liabilities and stockholders’equity……………… $1,000,000 $1,300,000 $1,894,000 Required: Question 1 (30 marks) (a) How much interest will be paid on debt in the proposed capital structures?