Sapphire is an all-equity financed company, which is valued at €250 million. The firm’s shares are expected to produce a return of 15 per cent. The company has decided to modify its capital structure to capture the tax benefits of debt. The plan is to have a target debt/equity ratio of 25 per cent. The company has been told that any borrowings made by them will attract a rate of 7 per cent.
1. Calculate the return on equity of Sapphire before and after the restructuring. (20 marks)
2 .Write a brief report to the management of Sapphire explaining why the return on equity has changed as a result of restructuring. (20 marks)
3. What is meant by gearing? How does gearing affect the financial risk of a firm? (20 marks)
4. Assume that the corporate tax rate is 35 per cent, capital gains tax is zero and the personal income tax rate is 45 per cent. What is the value of Sapphire before the restructuring?
What is its value after? (20 marks)
5. What would the personal rate of tax on interest income have to be to push the tax advantage of debt to zero? (20 marks)