(^88) Financial Management
policy, that is, the capital structure remains constant, there would be no change in its
financial leverage. As a result, the combined leverages would increase causing an
increase in its total risk. The firm, in order to keep its risk constant, may like to lower
its financial leverage. This could be done if the new investments are financed with
more equity than the firm has used in the past. This would lower the financial leverage
and compensate for the increased operating leverage caused by investment in more
risky investments. If the operating leverage has decreased due to low fixed costs, the
firm can afford to have a more levered financial plan to keep the total risk constant at
the same time having the same prospects of magnifying effects on EPS due to change
in sales.
Solved Problems
- B Corporation is considering a new project which will require the purchase of a
new machine at a cost of 250,000. The project will also require use of a machine
which has been fully depreciated but which could be sold today for 30,000. In
addition, the firm expects an increase in net working capital investment of 60,000
in the first year of the project. What is the incremental net investment at the
outset of this project? How much of this incremental net investment will the firm
be able to depreciate?
Solution
The incremental investment includes both the cash required to purchase the new
machine and the after-tax disposal value of the old machine, which is calculated
as follows:
Gain on sale = Market value - Book value = 30,000 -0 = 30,000.
Taxes on gain = Gain Tax rate = (30,000)(0.40) = 12,000
Thus the firm's incremental investment flows are:
Cost of new machine : 250,000
Increase in net working capital 60,000
Market value of old machine -30,000
Tax on gain of sale of old machine : 12,000
Incremental investment outlay 292,000
The firm's depreciable value for tax purposes will be only the 250,000 cost of the
new machine. (If the old machine had remaining book value, the incremental tax
basis would be reduced by the loss of this book value.)- The Stupid Company is considering a project requiring the purchase of a new
machine costing Rs 200,000. The machine will be depreciated on a straight-line