Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK?

Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK?

As we computed the financial leverage for CPK from 1-1-2006 to 1-7-200, we have found that the financial leverage was 28% in 1-1-2006, 32.5% in 32-12-2006 and 33.5% in 1-7-2007. The financial leverage of the company has slightly increased during 1.5%

The financial leverage increasing may improve the ROE for a company because a company could outsource money in the utilization of a company’s operations with a few or even without requiring investments from equity.

Looking at a company’s income statement during 2006 to 2007 in Exhibit 3, we find that the net income was 19,490 and 21,000.

Calculating the ROE, we found the ROE was 9.88% in 2006 and 10.08% in 2007. This means that the ROE of the company has improved because they had expanded their business by using higher debt for the company’s operations while slightly increasing the equity as part of the expansion.

As for the cost of capital, our calculation has shown a different WACC for three different Debt/total capital scenarios of 10%, 20% and 30% in Exhibit 9. Posed at 8.35%, 8.82%, and 8.17% respectively. The financial leverage impact to cost of capital in term of increasing the financial leverage was the WACC decrease due to the proportion differentiation of debt to total capital from 10%, 20% and 30% respectively.

The effects of financial leverage on BETA was the increase the ROE but it entails high risk. The second concern that we have was the effect of leverage on the WACC by calculating the company’s beta using the CAPM model. The unlevered beta was 0.85, which is the beta of the company without any debt. It removes the financial effects from leverage. We have used the formula “ Where BL is the firms’ beta with leverage, Tc is the tax rate and D/E is the company’s debt to equity ratio. Coming with 0.87, 0.89, and 0.915 at a debt to total capital of 10%, 20% and 30% respectively.

The effects if financial leverage on cost of equity was that the higher the financial leverage, the higher the cost of equity as we have calculated in exhibit 9. We have concluded this after we have used the formula Rf= Rf+ Beta x (Rm – Rf)

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