Question

QUESTION 2

(a) Suppose XYZ Corporation has decided in favor of a capital restructuring that

involves increasing its existing $5milion in debt to 25milion. The interest rate on the debt

is 12% and is not expected to change. The firm currently has one million shares

outstanding and the price per share is $40. If the restructuring is expected to increase the

return on equity, what is the minimum level for EBIT that XYZ’s management must be

expecting? Ignore taxes in your answer.(12mks)

(b) Discuss the causes of uncertainty or risk for the estimated cash flows of a project

(8mks)

10

Answer 1

(a) To calculate the minimum level of EBIT, we need to find the return on equity (ROE) before and after the capital restructuring.

Before the restructuring, the capital structure is 100% equity, so the ROE is equal to the return on assets (ROA).

ROA = EBIT / Total Assets

Since there is no debt, Total Assets = Total Equity = $40 * 1 million shares = $40 million

So, ROA = EBIT / $40 million

After the restructuring, the capital structure is 83.3% debt and 16.7% equity. The return on equity is calculated as follows:

ROE = (EBIT - Interest) / Equity

Equity = $40 * 1 million shares = $40 million

Interest = 12% * $25 million = $3 million

ROE = (EBIT - $3 million) / $40 million

The restructuring is expected to increase the ROE, so we can set the two ROE equations equal to each other and solve for EBIT:

EBIT / $40 million = (EBIT - $3 million) / $40 million * 0.167

EBIT = $9.6 million

Therefore, the minimum level of EBIT that XYZ's management must be expecting is $9.6 million.

(b) There are many causes of uncertainty or risk for the estimated cash flows of a project, including:

1. Market Risk: Changes in market conditions can affect the demand for a product or service, which can impact the revenue and cash flows of a project.

2. Economic Risk: Changes in macroeconomic factors such as inflation rates, interest rates, and exchange rates can affect the cost of materials, labor, and financing, which can impact the cash flows of a project.

3. Political Risk: Changes in government policies, regulations, or instability can affect the business environment and the cash flows of a project.

4. Operational Risk: Uncertainties in the operations of a project such as delays, equipment failure, and labor disputes can affect the timing and amount of cash flows.

5. Financial Risk: Uncertainties in the financing of a project such as changes in interest rates, credit ratings, and availability of funding can affect the cash flows of a project.

6. Technological Risk: Changes in technology or obsolescence can affect the competitiveness and profitability of a project.

7. Environmental Risk: Changes in environmental