Question
Three companies have the capital structures shown below. Company A B C Ordinary shares 900 600 200 8% debentures 0 400 450 Total 900 1,000
Three companies have the capital structures shown below.
Company | A | B | C |
Ordinary shares | £900 | £600 | £200 |
8% debentures | £0 | £400 | £450 |
Total | £900 | £1,000 | £650 |
The return on capital employed was 34% for each firm in 2101, and in 2102 was 28%. Corporation tax in both years was assumed to be 25%, and debenture interest is an allowable expense against corporation tax.
Required:
(a) Calculate the percentage return on the shareholders’ capital for each company for 2101 and 2102. Assume that all profits are distributed. (b) Use your answer to explain the merits and dangers of high gearing.
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