You Were Hired as the CFO of a New Company

question 30

Multiple Choice

You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL ? ROEU? $\begin{array}{lrr}&\underline{0 \% \text { Debt, } \mathrm{U} }& \underline{60 \% \text { Debt. }}\\\text { Expected unit sales (Q) } & 28,500 & 28,500 \\\text { Price per phone (P) } & \$ 250.00 & \$ 250.00 \\\text { Fixed costs (F) } & \$ 1,000,000 & \$ 1,000,000 \\\text { Variable cost/unit (V) } & \$ 200.00 & \$ 200.00 \\\text { Required investment } & \$ 2,500,000 & \$ 2,500,000 \\\% \text { Debt } & 0.00 \% & 60.00 \% \\\text { Debt, \$ } & \$ 0 & \$ 1,500,000 \\\text { Equity, \$ } & \$ 2,500,000 & \$ 1,000,000 \\& & \\\text { Interest rate } & \mathrm{NA} & 10.00 \% \\\text { Tax rate } & 35.00 \% & 35.00 \%\end{array}$

• A) 5.68%
• B) 5.94%
• C) 6.22%
• D) 6.52%
• E) 6.83%

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Definitions:

Net Present Value

An economic measure that determines the disparity between the current value of cash coming in and the current value of cash going out over a specific timeframe.

Internal Rate Of Return

The break-even discount rate at which a project's cash flows net present value is zero.

Present Value

Present value represents the contemporary worth of a future sum or cash flow sequence, discounted by a certain return rate.

Payback Method

A capital budgeting technique that calculates the amount of time required to recoup the original investment.