1. Explain, in your own words, when and how the composition of capital (the mix of debt and equity) does not affect the value of the firm (i.e. the total value of debt and equity to creditors and shareholders).
2. Discuss this statement: "leverage gives the illusion of higher returns".
3. Would you expect the companies below to distribute a relatively high or low proportion of current earnings?
a. Companies that have experienced an unexpected decline in profits
b. Growth companies with valuable future investment opportunities
c. Mature companies with cash that exceed future investment needs
4. You have been hired as a consultant to the board of directors of a company. A board member asks you to craft a short presentation to the board advising on the relevance of taxation issues (dividends vs capital gain) for dividend policy.
5. Calculate the after tax return on equity (ROE) for the following firm:
Total value of assets: $150m
Capital structure: 50% equity, 50% debt
Return on assets: 10%
Interest rate: 6%
Tax rate: 30%
What happens to the ROE if the capital structure changes to 10% equity and 90% debt? What does this illustrate?