FIN 370 UNIVERSITY OF PHOENIX CHAPT 20 QUESTION 3

  

3. Fill in the table using the following information.

   

Assets required for operation: $10,000

   

Firm A uses only equity financing

   

Firm B uses 30% debt with a 6% interest rate and 70% equity

   

Firm C uses 50% debt with a 10% interest rate and 50% equity

   

Firm D uses 50% preferred stock financing with a dividend rate of 10%

   

and 50% equity financing

   

Earnings before interest and taxes: $1,000

   

                                                                 A                         B                      C                          D

 

Debt outstanding                                                           $                                   $                              $                                    $

   

Stockholders’ equity

   

Earnings before interest and taxes 300 300 300

   

Interest expense

   

Earnings before taxes

   

Taxes (40% of earnings)

   

Net earnings

   

Return on stockholders’ equity                                                 %                                          %                              %                             %

          

What happens to the return on the stockholders’ investment as the

   

amount of debt increases? Why is the rate of interest greater in case C?

   

Why is the return lower when the firm uses preferred stock instead of

   

debt? Why does the use of preferred stock involve less risk for the firm

   

than a comparable use of debt financing?