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a)Nkaissery Agencies is currently seeking to expand its scale of operations by venturing into a new project of manufacturing goat milk. The managers of the...

a) Nkaissery Agencies is currently seeking to expand its scale of operations by venturing into a new project of manufacturing goat milk. The managers of the firm expect the new project to generate earnings before interest and taxes of 20 percent for an investment of Kshs 25,000,000. The firm expects to raise the funds either by floating 1,000,000 shares of Kshs 25 per share or raising a quarter of the funds through equity and the rest through a loan at an interest of 12% p.a.

i) If the corporate tax is 30 percent, which of the above plans will maximize shareholder`s earnings? Why? (5 marks)

ii) What is the interest shield associated with the financial leverage? (1 mark)

Answers

Caroline



Solution





Item
Plan 1 (all equity)
Plan 2 (debt –equity)

EBIT (20%)
5,000,000
5,000,000

Less INTEREST (12%)
0
2,250,000

Profit before tax
5,000,000
2,750,000

Less Taxes (30%)
1,500,000
825,000

Profit after taxes (PAT)
3,500,000
1,925,000

EPS = PAT/No of shares or ROE=PAT/Equity
3.5
14%
7.7
30.8%

Conclusion
Plan 2 has higher returns



ITS = 30% * 18,750,000 = 5,620,500
















Carolinemakenamutwiri answered the question on December 14, 2018 at 11:11

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