P12-22. EBIT-EPS and capital structure
LG 5; Intermediate
a. Using $50,000 and $60,000 EBIT:
Structure A Structure B
EBIT $50,000 $60,000 $50,000 $60,000
Less: Interest 16,000 16,000 34,000 34,000
Financial breakeven points:
Structure A Structure B
$16,000 $34,000
b.
d. Structure A has less risk and promises lower returns as EBIT increases. Structure B is more risky because it has a
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2 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
P12-23. EBIT-EPS and preferred stock
LG 5: Intermediate
a.
Structure A Structure B
EBIT $30,000 $50,000 $30,000 $50,000
Less: Interest 12,000 12,000 7,500 7,500
Net profits before taxes $18,000 $38,000 $22,500 $42,500
Less: Taxes 7,200 15,200 9,000 17,000
b.
c. Structure A has greater financial leverage, hence greater financial risk.
P12-24. Integrative—optimal capital structure
LG 3, 4, 6; Intermediate
a.
Debt Ratio 0% 15% 30% 45% 60%
EBIT $2,000,0
00
$2,000,000 $2,000,000 $2,000,000 $2,000,000
Less: Interest
120,000 270,000 540,000 900,000
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Chapter 3: Financial Statements and Ratio Analysis 3
00
Net profit $1,200,0
00
$1,128,000 $1,038,000 $ 876,000 $ 660,000
Less: Preferred
5.00
b.
=
0
EPS
s
Pr
Debt: 0% Debt: 15%
= =
0
$5.00 $41.67
0.12
P
= =
0
$5.46 $42.00
0.13
P
Debt: 30% Debt: 45%
= =
0
$5.99 $42.79
0.14
P
= =
0
$6.15 $38.44
0.16
P
Debt: 60%
= =
0
$5.75 $28.75
0.20
P
P12-25. Integrative—Optimal capital structures
LG 3, 4, 6; Challenge
a. 0% debt ratio
Probability
0.20 0.60 0.20
Sales $200,000 $300,000 $400,000
Less: Variable costs (40%) 80,000 120,000 160,000
20% debt ratio:
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4 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
Total capital $250,000 (100% equity 25,000 shares $10 book value)
Probability
0.20 0.60 0.20
EBIT $20,000 $80,000 $140,000
Less: Interest 5,000 5,000 5,000
40% debt ratio:
Probability
0.20 0.60 0.20
EBIT $20,000 $80,000 $140,000
60% debt ratio:
Probability
0.20 0.60 0.20
EBIT $20,000 $80,000 $140,000
Debt CV
Number
of
Common
Dollar
Amount
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Chapter 3: Financial Statements and Ratio Analysis 5
Ratio E(EPS) EP
S)
(EPS) Shares of Debt Share Price*
0% $1.92 0.9107 0.4743 25,000 0 $1.92/0.16 $12.00
*Share price: E(EPS) required return for CV for E(EPS), from table in problem.
b. (1) Optimal capital structure to maximize EPS: 60% debt
40% equity
c.
P12-26. Integrative—optimal capital structure
LG 3, 4, 5, 6; Challenge
a.
% Debt Total Assets $ Debt $ Equity No. of Shares @ $25
0 $40,000,000 $ 0 $40,000,000 1,600,000
10 40,000,000 4,000,000 36,000,000 1,440,000
b.
% Debt $ Total Debt Before Tax Cost of Debt, kd$ Interest Expense
0 $ 0 0.0% $ 0
10 4,000,000 7.5 300,000
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6 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
50 20,000,000 12.5 2,500,000
60 24,000,000 15.5 3,720,000
c.
%
Debt
$ Interest
Expense EBT
Taxes
@40% Net Income
# of
Shares EPS
0 $ 0 $8,000,000 $3,200,000 $4,800,000 1,600,000 $3.00
10 300,000 7,700,000 3,080,000 4,620,000 1,440,000 3.21
d.
% Debt EPS rSP0
0 $3.00 10.0% $30.00
10 3.21 10.3 31.17
20 3.45 10.9 31.65
e. The optimal proportion of debt would be 30% with equity being 70%. This mix will maximize the price per share
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