Question
Three companies have the capital structures shown below. Company A B C Ordinary shares 800 500 150 10% debentures 0 350 450 Total 800 850
Three companies have the capital structures shown below.
Company | A | B | C |
Ordinary shares | £800 | £500 | £150 |
10% debentures | £0 | £350 | £450 |
Total | £800 | £850 | £600 |
The return on capital employed was 27% for each firm in 2041, and in 2042 was 18%. Corporation tax in both years was assumed to be 5%, and debenture interest is an allowable expense against corporation tax.
Required:
(a) Calculate the percentage return on the shareholders’ capital for each company for 2041 and 2042. Assume that all profits are distributed. (b) Use your answer to explain the merits and dangers of high gearing.
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