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EBIT and Leverage Control, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $6,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 60 percent lower. Control is considering a $40,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem.

a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.

b. Repeat part (a) assuming that Control goes through with recapitalization. What do you observe?

EBIT, Taxes, and Leverage Repeat parts (a) and (b) in Problem 1 assuming Control has a tax rate of 35 percent.

ROE and Leverage Suppose the company in Problem 1 has a market-to-book ratio of 1.0.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

© The McGraw-Hill Companies, 2002

CHAPTER 17 Financial Leverage and Capital Structure Policy a. Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes.

b. Repeat part (a) assuming the firm goes through with the proposed recapitalization.

c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent.

Break-Even EBIT Linkin Park Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Linkin Park would have 100,000 shares of stock outstanding. Under Plan II, there would be 50,000 shares of stock outstanding and $1.5 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes.

a. If EBIT is $200,000, which plan will result in the higher EPS?

b. If EBIT is $700,000, which plan will result in the higher EPS?

c. What is the break-even EBIT?

M&M and Stock Value In Problem 4, use M&M Proposition I to find the price per share of equity under each of the two proposed plans. What is the value of the firm?

Break-Even EBIT and Leverage Taylor Corp. is comparing two different capital structures. Plan I would result in 800 shares of stock and $9,000 in debt. Plan II would result in 700 shares of stock and $13,500 in debt. The interest rate on the debt is 10 percent.

a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $8,000. The all-equity plan would result in 1,000 shares of stock outstanding. Which of the three plans has the highest EPS? The lowest?

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Is one higher than the other? Why?

c. Ignoring taxes, when will EPS be identical for Plans I and II?

d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 40 percent. Are the break-even levels of EBIT different from before? Why or why not?

Leverage and Stock Value Ignoring taxes in Problem 6, what is the price per share of equity under Plan I? Plan II? What principle is illustrated by your answers?

Homemade Leverage Zombie, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently, there are 1,000 shares outstanding and the price per share is $70. EBIT is expected to remain at $7,000 per year forever. The interest rate on new debt is 7 percent, and there are no taxes.

a. Ms. Spears, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?

b. What will Ms. Spears's cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares.

c. Suppose Zombie does convert, but Ms. Spears prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.

d. Using your answer to part (c), explain why Zombie's choice of capital structure is irrelevant.

Basic

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