P12-21 Eps And Optimal Debt Ratio Williams Glassware Has Estimated At Various Debt Ratios The Expected Earnings Per Share And The Standard Deviation Of The Earnings Per Share As Shown In The Following Table.

The Complete Debt Relief Manual

Get Instant Access

Personal Finance Problem

Financial leverage Max Small has outstanding school loans that require a monthly payment of \$1,000. He needs to purchase a new car for work and estimates that this will add \$350 per month to his existing monthly obligations. Max will have \$3,000 available after meeting all of his monthly living (operating) expenses. This amount could vary by plus or minus 10%.

a. In order to assess the potential impact of the additional borrowing on his financial leverage, calculate the DFL in tabular form for both the current and proposed loan payments using Max's available \$3,000 as a base and a 10% change, b- Can Max afford the additional loan payment? c. Should Max take on the additional loan payment?

DFL and graphical display of financing plans Wells and Associates has EBIT of \$67,500. Interest costs are \$22,500, and the firm has 15,000 shares of common stock outstanding. Assume a 40% tax rate.

a. Use the degree of financial leverage (DFL) formula to calculate the DFL for the firm.

b. Using a set of EBIT-EPS axes, plot Wells and Associates' financing plan.

c. If the firm also has 1,000 shares of preferred stock paying a \$6.00 annual dividend per share, what is the DFL?

d. Plot the financing plan, including the 1,000 shares of \$6.00 preferred stock, on the axes used in part b.

e. Briefly discuss the graph of the two financing plans.

Integrative—Multiple leverage measures Play-More Toys produces inflatable beach balls, selling 400,000 balls per year. Each ball produced has a variable operating cost of \$0.84 and sells for \$1.00. Fixed operating costs are \$28,000. The firm has annual interest charges of \$6,000, preferred dividends of \$2,000, and a 40% tax rate.

a. Calculate the operating breakeven point in units.

b. Use the degree of operating leverage (DOL) formula to calculate DOL.

c. Use the degree of financial leverage (DFL) formula to calculate DFL.

d. Use the degree of total leverage (DTL) formula to calculate DTL. Compare this to the product of DOL and DFL calculated in parts b and c.

Integrative—Leverage and risk Firm R has sales of 100,000 units at \$2.00 per unit, variable operating costs of \$1.70 per unit, and fixed operating costs of \$6,000. Interest is \$10,000 per yean Firm W has sales of 100,000 units at \$2.50 per unit, variable operating costs of \$1.00 per unit, and fixed operating costs of \$62,500. Interest is \$17,500 per year. Assume that both firms are in the 40% tax bracket.

a. Compute the degree of operating, financial, and total leverage for firm R.

b. Compute the degree of operating, financial, and total leverage for firm W.

c. Compare the relative risks of the two firms.

BJM^fl Integrative—Multiple leverage measures and prediction Carolina Fastener Inc., makes a patented marine bulkhead latch that wholesales for \$6.00. Each latch has variable operating costs of \$3.50. Fixed operating costs are \$50,000 per year. The firm pays \$13,000 interest and preferred dividends of \$7,000 per year. At this point, the firm is selling 30,000 latches per year and is taxed at a rate of 40%.

a. Calculate Carolina Fastener's operating breakeven point.

b. On the basis of the firm's current sales of 30,000 units per year and its interest and preferred dividend costs, calculate its EBIT and earnings available for common.

c. Calculate the firm's degree of operating leverage (DOL).

d. Calculate the firm's degree of financial leverage (DFL).

e. Calculate the firm's degree of total leverage (DTL).

f. Carolina Fastener has entered into a contract to produce and sell an additional 15,000 latches in the coming year. Use the DOL, DFL, and DTL to predict and calculate the changes in EBIT and earnings available for common. Check your work by a simple calculation of Carolina Fastener's EBIT and earnings available for common, using the basic information given.

_ Personal Finance Problem

QE3EI Capital structure Kirsten Neal is interested in purchasing a new house given that mortgage rates are at a historical low. Her bank has specific rules regarding an applicant's ability to meet the contractual payments associated with the requested debt. Kirsten must submit personal financial data for her income, expenses, and existing installment loan payments. The bank then calculates and compares certain ratios to predetermined allowable values to determine if it will make the requested loan. The requirements are as follows:

(1) Monthly mortgage payments < 28% of monthly gross (before-tax) income.

(2) Total monthly installment payments (including the mortgage payments) < 37% of monthly gross (before-tax) income.

Kirsten submits the following personal financial data:

Monthly gross (before-tax) income Monthly installment loan obligations Requested mortgage Monthly mortgage payments a. Calculate the ratio for requirement 1.

b. Calculate the ratio for requirement 2.

c. Assuming that Kirsten has adequate funds for the down payment and meets other lender requirements, will Kirsten be granted the loan?

Various capital structures Charter Enterprises currently has \$1 million in total assets and is totally equity-financed. It is contemplating a change in its capital structure. Compute the amount of debt and equity that would be outstanding if the firm were to shift to each of the following debt ratios: 10%, 20%, 30%, 40%, 50%, 60%, and 90%. (Note: The amount of total assets would not change.) Is there a limit to the debt ratio's value?

Debt and financial risk Tower Interiors has made the forecast of sales shown in the following table. Also given is the probability of each level of sales.

400,000 .20

The firm has fixed operating costs of \$75,000 and variable operating costs equal to 70% of the sales level. The company pays \$12,000 in interest per period. The tax rate is 40%.

a. Compute the earnings before interest and taxes (EBIT) for each level of sales.

b. Compute the earnings per share (EPS) for each level of sales, the expected EPS, the standard deviation of the EPS, and the coefficient of variation of EPS, assuming that there are 10,000 shares of common stock outstanding.

c. Tower has the opportunity to reduce its leverage to zero and pay no interest. This will require that the number of shares outstanding be increased to 15,000. Repeat part b under this assumption.

d. Compare your findings in parts b and c, and comment on the effect of the reduction of debt to zero on the firm's financial risk.

EPS and optimal debt ratio Williams Glassware has estimated, at various debt ratios, the expected earnings per share and the standard deviation of the earnings per share as shown in the following table.

! v Debt ratio Earnings per share (EPS) . . Standard deviation of EPS .

a. Estimate the optimal debt ratio on the basis of the relationship between earnings per share and the debt ratio. You will probably find it helpful to graph the relationship.

b. Graph the relationship between the coefficient of variation and the debt ratio. Label the areas associated with business risk and financial risk.

§ PI 2-22 EBFT-EPS and capital structure Data-Check is considering two capital structures. The key information is shown in the following table. Assume a 40% tax rate.

¡^Source ;o€ jj^1 ■:'/,;:" ;5iOTCtnire: A

Long-term debt \$100,000 at 16% coupon rate \$200,000 at 17% coupon rate Common stock 4,000 shares 2,000 shares a. Calculate two EBIT-EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values.

b. Plot the two capital structures on a set of EBIT-EPS axes.

c. Indicate over what EBIT range, if any, each structure is preferred.

d. Discuss the leverage and risk aspects of each structure.

e. If the firm is fairly certain that its EBIT will exceed \$75,000, which structure would you recommend? Why?

EBIT-EPS and preferred stock Litho-Print is considering two possible capital structures, A and B, shown in the following table. Assume a 40% tax rate.

coupon rate coupon rate

Preferred stock \$10,000 with an 18% \$15,000 with an 18%

annual dividend annual dividend

Common stock 8,000 shares 10,000 shares a. Calculate two EBIT-EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values.

b. Graph the two capital structures on the same set of EBIT-EPS axes.

c. Discuss the leverage and risk associated with each of the structures.

d. Over what range of EBIT is each structure preferred?

e. Which structure do you recommend if the firm expects its EBIT to be \$35,000? Explain.

Integrative—Optimal capital structure Medallion Cooling Systems, Inc., has total assets of \$10,000,000, EBIT of \$2,000,000, and preferred dividends of \$200,000 and is taxed at a rate of 40%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:

15 8 170,000 13

30 9 140,000 14

45 12 110,000 16

60 15 80,000 20

a. Calculate earnings per share for each level of indebtedness.

b. Use Equation 12.12 and the earnings per share calculated in part a to calculate a price per share for each level of indebtedness.

c. Choose the optimal capital structure. Justify your choice.

t 'IVBrH Integrative—Optimal capital structure Nelson Corporation has made the following forecast of sales, with the associated probabilities of occurrence noted.

The company has fixed operating costs of \$100,000 per year, and variable operating costs represent 40% of sales. The existing capital structure consists of 25,000 shares of common stock that have a \$10 per share book value. No other capital items are outstanding. The marketplace has assigned the following required returns to risky earnings per share.

. Coefficient of" • ' Esriouted required y'! ^^yairârioii-of'EIîS 'i

0.47 16

0.51 17

0.60 22

0.64 24

The company is contemplating shifting its capital structure by substituting debt in the capital structure for common stock. The three different debt ratios under consideration are shown in the following table, along with an estimate, for each ratio, of the corresponding required interest rate on all debt.

;j;,Debt. titercst.tate.

60 14

The tax rate is 40%. The market value of the equity for a leveraged firm can be found by using the simplified method {see Equation 12.12).

a. Calculate the expected earnings per share (EPS), the standard deviation of EPS, and the coefficient of variation of EPS for the three proposed capital structures.

b. Determine the optimal capital structure, assuming (1) maximization of earnings per share and (2) maximization of share value.

c. Construct a graph (similar to Figure 12.7) showing the relationships in part b. {Note: You will probably have to sketch the lines, because you have only three data points.)

P12-26 Integrative—Optimal capital structure The board of directors of Morales

Publishing, Inc., has commissioned a capital structure study. The company has total assets of \$40,000,000. It has earnings before interest and taxes of \$8,000,000 and is taxed at a rate of 40%.

a. Create a spreadsheet like the one in Table 12.10 showing values of debt and equity as well as the total number of shares, assuming a book value of \$25 per share.

b. Given the before-tax cost of debt at various levels of indebtedness, calculate the yearly interest expenses.

f'fy, i^S ■■pt^t^.^i^ic.1 -^C^ Interest expense ;

c. Using EBTT of \$8,000,000, a 40% tax rate, and the information developed in parts a and b, calculate the most likely earnings per share for the firm at various levels of indebtedness. Mark the level of indebtedness that maximizes EPS.

d. Using the EPS developed in part c, the estimates of required return, rs, and Equation 12.12, estimate the value per share at various levels of indebtedness. Mark the level of indebtedness in the table on page 594 that results in the maximum price per share, Pq.

e. Prepare a recommendation to the board of directors of Morales Publishing that specifies the degree of indebtedness that will accomplish the firm's goal of optimizing shareholder wealth. Use your findings in parts a through d to justify your recommendation.

integrative—Optimal capital structure Country Textiles, which has fixed operating costs of \$300,000 and variable operating costs equal to 40% of sales, has made the following three sales estimates, with their probabilities noted.

900,000 .40

The firm wishes to analyze five possible capital structures—0%, 15%, 30%, 45%, and 60% debt ratios. The firm's total assets of \$1 million are assumed to be constant. Its common stock has a book value of \$25 per share, and the firm is in the 40% tax bracket. The following additional data have been gathered for use in analyzing the five capital structures under consideration.

; ¿Capital structure Before-tax cost Required. k . debt ratio fffi'^j&fflfyt:i \ return; rs

a. Calculate the level of EBIT associated with each of the three levels of sales.

b. Calculate the amount of debt, the amount of equity, and the number of shares of common stock outstanding for each of the five capital structures being considered.

c. Calculate the annual interest on the debt under each of the five capital structures being considered. (Note: The before-tax cost of debt, r¿, is the interest rate applicable to all debt associated with the corresponding debt ratio.)

d. Calculate the EPS associated with each of the three levels of EBrT calculated in part a for each of the five capital structures being considered, e. Calculate (1) the expected EPS, (2) the standard deviation of EPS, and (3) the coefficient of variation of EPS for each of the five capital structures, using your findings in part d.

f. Plot the expected EPS and coefficient of variation of EPS against the capital structures (x axis) on separate sets of axes, and comment on the return and risk relative to capital structure.

g. Using the EBIT-EPS data developed in part d, plot the 0%, 30%, and 60% capital structures on the same set of EBIT-EPS axes, and discuss the ranges over which each is preferred. What is the major problem with the use of this approach?

h. Using the valuation model given in Equation 12.12 and your findings in part e, estimate the share value for each of the capital structures being considered.

i. Compare and contrast your findings in parts f and h. Which structure is preferred if the goal is to maximize EPS? Which structure is preferred if the goal is to maximize share value? Which capital structure do you recommend? Explain.

O PI 2-28 ETHICS PROBLEM "Informarion asymmetry lies at the heart of the ethical W} dilemma that managers, stockholders, and bondholders confront when companies initiate management buyouts or swap debt for equity." Comment on this statement. What steps might a board of directors take to ensure that the company's actions are ethical to all parties?

Chapter 12 Case

Evaluating Tampa Manufacturing's Capital Structure

Tampa Manufacturing, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm's board has instructed its management to institute programs that will allow it to operate more efficiendy, earn higher profits, and, most important, maximize share value. In this regard, the firm's chief financial officer (CFO), Jon Lawson, has been charged with evaluating the firm's capital structure. Lawson believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm's capital structure, Lawson has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures—A (30% debt ratio) and B (50% debt ratio)—that he would like to consider.

V;';■'"'■■'f-"-:':.-.".■_."::l^r-x î'.v."^'-v"-^ív^'i*''¡v Capital structure*

Long-term debt \$1,000,000 \$3,000,000 \$5,000,000

Coupon interest rate6 9% 10% 12%

Common stock 100,000 shares 70,000 shares 40,000 shares

Required return on equity, rsc 12% 13% 18%

"These structures are based on maintaining the firm's current level of \$10,000,000 of total financing. ^Interest rate applicable to aU debt. «Market-based return for the given level of risk.

Lawson expects the film's earnings before interest and taxes (EBIT) to remain at its current level of \$1,200,000. The firm has a 40% tax rate.

To Do a. Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the current and two alternative capital structures using the times interest earned and debt ratios.

b. Prepare a single EBIT-EPS graph showing the current and two alternative capital structures.

c. On the basis of the graph in part b, which capital structure will maximize Tampa's earnings per share (EPS) at its expected level of EBIT of \$1,200,000? Why might this not be the best capital structure?

d. Using the zero-growth valuation model given in Equation 12.12, find the market value of Tampa's equity under each of the three capital structures at the \$1,200,000 level of expected EBIT.

e. On the basis of your findings in parts c and d, which capital structure would you recommend? Why?

Starstruck Company would like to determine its optimal capital structure. Several of its managers believe that the best method is to rely on the estimated earnings per share (EPS) of the firm, because they feel that profits and stock price are closely related. The financial managers have suggested another method that uses estimated required returns to estimate the share value of the firm. The following financial data are available.

. Capital structure idcbV ratfo

^Estimated