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Exercise 8-2 , p . 489
Analyzing Returns and Strategies of Alternative Financing
Roll Corporation ’ s return on net operating assets ( RNOA ) is 10 % and its tax rate is 40 %. Its net operating assets ($ 10 million ) are financed entirely by common shareholders ’ equity . Management is considering using bonds to finance an expansion costing $ 6 million . It expects return on net operating assets to remain unchanged . There are two alternatives to finance the expansion :
1 . Issue $ 2 million bonds with 5 % coupon and $ 4 million common stock
2 . Issue $ 6 million bonds with 6 % coupon .
Required :
a . Compute Roll ’ s current net operating income after tax ( NOPAT ) and net income .
b . Determine net income and net operating income after tax for each alternative financing plan
c . Compute return on common shareholders ’ equity for each alternative ( use ending equity ).
d . Explain any difference in the ROCE for the alternative plans computed in ( c ). Include a discussion of leverage in your response .