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 assay if there is a high probability that it might be inefficient to meet its fixed financial obligations or prior chares such as interest, nous 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 firms 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 firms trading 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 optimal take aim, 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-te rm 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 licitly 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 be 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 one time 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 require identify of picture.Under this section, the required rate o f return is calculated under the assumption that the risk level of the new enthronisation remains the same as the risk of the original investment. This calculation is done forrader and after the issue of the new debentures. Having said this we now calculate the required rate of return beforehand 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 saucily Debentures.1Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 disport (8% of 320,000) 25.600 Earnings after interest 46.400 Number of shares heavy(p)130.000Earnings per share (EPS)0,3569Book Value 260.000Book Value per share2Expected Return on ordinary equity shares (ROE)17,85%b) Required Rate of Return for WCOA Ordinary Shareholders after the issue of the New Debentures.2Earnings from original investments 64.000 Earnings from new investment 8.000 Total Earnings before interest 72.000 Interest (8% of 400,000)