MGT201 GDB 2 Solution Feb 2015


ABC is an all equity based firm having total assets of Rs.10 million invested equally by the ten members of the firm. Later; five of the members decided to leave the firm with the idea of investing their money into other businesses of their varying interest. The firm takes a bank loan of Rs. 5 million (at 10% p.a.) and pays back the equity capital to those five owners leaving the firm. Thus, half of the equity is replaced with the bank loan.

Being a financial analyst, you are required to suggest that:

1.     What impact does this situation have on Return on Equity (ROE) of the firm and Total Return to its Investors?

2.     Is it beneficial to add more and more debt to the firm’s capital structure? Support your answer with logic