3 Darnol plc is currently ungeared and is considering a buy-back of ordinary shares via an open market purchase, borrowing in order to do so. You have been commissioned to report on the likely impact of two alternative policies, depending on the level of sales and operating profit for its products. You are given the following information:

Equity is currently £200 million at book value. Tax is paid at 30 per cent. Two alternative share buy-back programmes are under consideration:
(i) Borrowing £40 million at 8 per cent.
(ii) Borrowing £80 million at 8.5 per cent.
Required

(a) Calculate the current, and potential expected annual return on equity (ROE) under each programme.

(b) Calculate the standard deviation of the ROE in each case.

(c) Using the figures you have obtained, explain and illustrate the distinction between business and financial risk.

Transcribed Image Text:

Level of sales PBIT Probability Weak 5 m 0.3 Average 50 m 0.5 Strong 150 m 0.2