Business and Financial Environment 2 Essay Example | Topics and Well Written Essays - 2000 words

Business and Financial Environment 2 - Essay Example (Moles and Terry, 1997). A firm faces finances risk if there is a high probability that it might be unable to meet its fixed financial obligations or prior chares such as interest, principal repayments, lease payments, or preferred stock dividends. Financial risk is therefore risk arising from the use of debt finance, which requires periodic payments of interest and principal and may not be covered by the firm's operating cash flows. (Moles and Terry, 1997). The capital structure of a firm is made up of both debt and equity components. Although the use of debt in financing part of the firm's operations is advantageous to the firm, these advantages tend to disappear when too much debt is used. In effect when debt is used above the optimum level, the result is financial distress. (Ross et al, 1999). Ross et al (1999) asserts that debt puts pressure on the firm, since interest and principal repayments as well as short-term payables are financial obligations. In the event where these obligations are not met, the firm may risk some sort of financial distress. (Ross et al, 1999). Debt obligations are fundamentally different from stock obligations in that bondholders are legally entitled to interest and principal repayments more than stockholders are legally entitled to dividends. (Ross et al, 1999). ... (Ross et al, 1999). Although debt carries a tax advantage, the costs of financial distress tend to offset this advantage when debt is used above the optimal level. (Ross et al, 1999). The optimal level of debt can be referred to as the debt level that provides the maximum firm value. the value of the firm begins to disappear once this debt level is exceeded. (Ross et al, 1999). The firm should therefore adopt a debt-to-equity ratio that maximizes the value of the firm. (Ross et al, 1999). Question (ii) WCOA Ltd Ordinary Shareholders' Required Rate of Return. Under this section, the required rate of return is calculated under the assumption that the risk class of the new investment remains the same as the risk of the original investment. This calculation is done before and after the issue of the new debentures. Having said this we now calculate the required rate of return before the issue of the new debentures and we later calculate the return after the issue of the new debentures. a) Required Rate of Return for WCOA Ordinary Shareholders Before the issue of the New Debentures.1 Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 Interest (8% of 320,000) 25.600 Earnings after interest 46.400 Number of shares outstanding 130.000 Earnings per share (EPS) 0,3569 Book Value 260.000 Book Value per share 2 Expected Return on ordinary equity shares (ROE) 17,85% b) Required Rate of Return for WCOA Ordinary Shareholders after the issue of the New Debentures.2 Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 Interest (8% of 400,000)