The stock price for each debt ratio alternative can be calculated by:
P/E Ratio = Stock Price
No Debt: 30 / 3.18 = 9.43Stock Price : $ 30
30% Debt:x / 3.33 = 9.43Stock Price : $31.4
50% Debt:x / 3.41 = 9.43Stock Price : $32.2
70% Debt:x / 3.49 = 9.43Stock Price : $32.9
Assumption : the P/E ratio remains constant for all the cases. The stock price, which represents the Value of the Firm, is the highest at $32.9 at the 70% debt ratio. This is in accordance with Figure 1, which shows that at lowest WACC (as calculated) the value of the firm will be maximum. These calculations show how the Equity Market will react to these changes in debt.
Capital Gain Yield
An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. capital loss is incurred when there is a decrease in the capital asset value compared to an asset's purchase price. The stock prices was used to calculate the CGY. CGY=((New Price – Old Price) / Old Price ) x 100
30% Debt:((31.4 – 30) / 30) x 100 = 4.67%
50 Debt:((32.3 – 30) / 30) x 100 = 7.33%
70% Debt:((32.9 – 30) / 30) x 100 = 9.67%
Note: Since there is no change in capital structure between year 1980 and 1981 following the no debt policy, the stock price is assumed to remain unchanged. Since capital gain yield determines the rate of return on any stock, this increase of 9.67% will be highly favorable for the investors.
Investopedia explains Return On Equity - ROE
The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the...