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    Finding Rate of return, ROCE for Solar Inc.

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    Problem

    Solar, Inc. has financial leverage of 36.0% and a net after-tax borrowing cost of 5% on $180 million of net debt. Its return on common equity (ROCE) is 28%.

    a. What rate of return does this firm earn on its operations?

    b. Solar, Inc. is considering repurchasing $120 million of its stock and financing the repurchase with further borrowing at a 5% after-tax borrowing cost. If the company wants to maintain the same level of operating profitability, what is the firm's return on common equity after this repurchasing?

    c. If its equity traded at $18.75 per share at the end of 2005 is expected to earn $1.80 per share in 2006 and $2.05 in 2007. Solar, Inc. pays no dividends and its long-term growth rate for residual earnings equal to 4%. Given these forecasts, what is the rate of return you expect to earn from buying the shares?

    d. Solar, Inc. reported its after-tax operating income of $220 million in 2005. Its net operating assets were increased from $1,885 million to $2,040 million between 2004 and 2005. During the same period, its sales revenue was increased from $4,050 million to $4,895 million. What was the normalized operating income for year 2005?

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    Solution Preview

    a.

    We know that ROCE=RNOA+FLEV*(RONA-NBC)
    Given
    ROCE=Return on common equity = 28%
    NBC=Net borrowing costs =5%
    FLEV=Financial leverage =36%
    Putting these values in above relation, we get
    28%=RNOA+36%*(RNOA-5%)
    1.36*RONA=29.8%
    RONA=21.91% ...

    Solution Summary

    Solution describes the steps in finding out rate of return, rate of return on common equity after repurchase and normalized operating income for Solar Inc.

    $2.19

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