978-0134476308 Chapter 12 Part 2

Chapter 12 Leverage and Capital Structure 271

P12-18 Personal finance: Capital structures (LG 3; Intermediate)

a. Monthly mortgage payment ÷ Monthly gross income = $1,100 ÷ $4,500 = 24.44%

P12-19 Various capital structures (LG 3; Basic)

Debt Ratio Debt Equity

10% $100,000 $900,000

P12-20 Debt and financial risk (LG 3; Challenge)

a. EBIT Calculation:

Probability 0.20 0.60 0.20

Sales $200,000 $300,000 $400,000

Less: Variable costs (70%) 140,000 210,000 280,000

σ

===

EPS

EPS 1.138 6.32

Expected EPS 0.18

CV

c.

EBIT * $(15,000) $15,000 $45,000

==EPS

$0.759 1.265

0.60

CV

d. Summary statistics:

of variation than the all-equity structure.

Eliminating debt from the firm’s capital structure

greatly reduces financial risk (as measured by the

coefficient of variation for EPS).

CVEPS 6.320 1.265

P12-21 EPS and optimal debt ratio (LG 4; Intermediate)

a.

0% 0.5

40 0.8

80 1.5

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

N

et profits before taxes $34,000 $44,000 $16,000 $26,000

Less: Taxes 13,600 17,600 6,400 10,400

N

et profit after taxes $20,400 $26,400 $ 9,600 $15,600

EPS (4,000 shares) $ 5.10 $ 6.60

EPS (2,000 shares) $ 4.80 $ 7.80

Financial breakeven points:

Structure A Structure B

$16,000 $34,000

Note: With a 21% tax rate. the EPS values (moving from left to right in the lower row of the

table above) are $6.72, $8.69, $6.32, and $10.27. The breakeven points do not change.

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Chapter

12 Leverage

a

nd Capital Stru

c

ture 275

278 Zutter/Smart • Principles of Managerial Finance Brief, Eighth Edition

Probability (p)

p

1 = 0.20 p2 = 0.60 p3 =0.20

***

Debt

Ratio

Expected

(EPS)

σ

(EPS)

CV(EPS)

Common

Shares

Total

Debt ($)

Share Price*

= Expected EPS

÷ Required Return

0% $1.92 0.9107 0.4743 25,000 0 $1.92÷0.16

=

$12.00

=

(2) Optimal capital structure to maximize share price: 40% debt, 60% equity

$41.67, $42.82, $40.75, $36.70, and $30.19.

P12-27 Integrative: Optimal capital structure (LG 3, 4, 5, 6; Challenge)

0.30 0.40 0.30

Sales $600,000 $900,000 $1,200,000

Less: Variable costs (40%) 240,000 360,000 480,000

Less: Fixed costs 300,000 300,000 300,000

EBIT $ 60,000 $240,000 $ 420,000

t

c.

Deb

t

Ratio

Amoun

t

of Debt

Before-Tax

Cost of Debt

Annual

Interest

0% $ 0 0.0% $ 0

15% 150,000 8.0 12,000

−

×

÷

=

−

×

÷

=

($240,000

−

$12,000)

×

(0.6)

÷

34,000 shares

=

4.02

($420,000

−

$12,000)

×

(0.6)

÷

34,000 shares

=

7.20

30% ($60,000 − $30,000) × (0.6) ÷ 28,000 shares = $0.64

($240,000

−

$30,000)

×

(0.6)

÷

28,000 shares

=

4.50

($420,000

−

$30,000)

×

(0.6)

÷

28,000 shares

=

8.36

−

×

÷

=

−

×

÷

=

−

×

÷

=

−

×

÷

=

×

+

×

+

×

0.27

+

1.44

+

1.89 = $3.60

15% 0.30 × (0.85) + 0.40 × (4.02) + 0.30 × (7.20)

+

0.19

+

1.80

+

2.51 = $4.50

45% 0.30 × (0.04) + 0.40 × (4.95) + 0.30 × (9.86)

+

−

0.47

+

2.07

+

3.58 = $5.18

(2) Standard deviation of EPS,

σ

EPS:

Debt Ratio Calculation

222

σ

EPS 7.232 0 7.232

σ

=++

= 3.803

22 2

−

×

÷

=

=(1 ) (EBIT )

EPS number of common shares outstanding

Set EPS 0% = EPS 30% and EPS 30% = EPS 60%. The first calculation, EPS 0% = EPS 30%, is

as follows:

−−−

=

[(1 0.4)(EBIT $0) 0]

EPS 40,000 shares

0% $3.60 ÷ 0.100 $36.00

15% $4.03 ÷ 0.105 $38.38

30% $4.50 ÷ 0.116 $38.79

45% $4.95 ÷ 0.140 $35.36

60% $5.18 ÷ 0.200 $25.90

P12-28 Ethics problem (LG 3; Intermediate)

An information asymmetry occurs when one party has more information than other interested parties.

Such an asymmetry can occur when managers overleverage or lead a company buyout Existing

bondholders and possibly stockholders could be harmed by the financial risk of overleveraging, and

existing stockholders will be harmed if they accept a buyout price below that consistent with accurate

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