978-0134476315 Chapter 13 Solution Manual Part 2

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P13-13 Personal finance: Financial leverage (LG 2; Challenge)

a. Current DFL Initial Values Future Value % ∆

Available for making loan payment

Less: Loan payments

$3,000

$1,000

$3,300

$1,000

10.0%

0.0%

Proposed DFL Initial Values Future Value % ∆

Available for making loan payment

$3,000

$3,300

10.0%

b. and c.

The amount Max will have available after loan payments with his current debt changes by

1.5% for every 1% change in the amount he will have available to make the loan payment.

This is less responsive and, therefore, less risky than the 1.82% change in the amount available

P13-14 DFL and graphic display of financing plans (LG 2, 5; Challenge)

a. Degree of financial leverage (DFL) is given by:

where:

EBIT = earnings before interest

and taxes

I = interest expense

d. See graph, which is based on the following equation and data points:

Financing EBIT EPS

Original

financing

$67,500

financing

plan

$17,500

e. The lines representing the two financing plans are parallel because the number of shares of

common stock outstanding is the same in each case. The financing plan, including the

preferred stock, leads to a higher financial breakeven point and lower EPS at any EBIT level.

P13-15 Integrative: Multiple leverage measures (LG 1, 2; Intermediate)

Let Q = unit sales, P = unit price, VC = variable costs, and FC = fixed costs.

b. Degree of operating leverage is given by:

c. Earnings before interest and taxes (EBIT)  (P  Q)  FC  (Q  VC)

where:

I = interest expense

DFL is 1.31.

Note: With a 21% tax rate, DTL is 2.33.

P13-16 Integrative: Leverage and risk (LG 2; Intermediate)

a. Let Q = unit sales, P = unit price, VC = variable costs, and FC = fixed costs.

So,

Now,

where:

There are no preferred dividends, so:

c. Firm R has less operating (business) risk but more financial risk than Firm W.

d. Two firms with differing operating and financial structures may be equally leveraged. Because

P13-17 Integrative—multiple leverage measures and prediction (LG 1, 2; Challenge)

a. Let Q = unit sales, P = unit price, VC = variable costs, and FC = fixed costs.

b. Sales ($6  30,000) $180,000

Less:

Fixed costs 50,000

Variable costs ($3.50  30,000) 105,000

Note: If the tax rate is 21% then net profits are $9,480, and earnings available for common

stockholders is $2,480.

So,

d. Degree of financial leverage (DFL) is given by:

where:

I = interest expense

So,

where:

EBIT = earnings before interest and taxes PD = dividends on

f. DOL = %∆ EBIT % ∆ sales, so %∆ EBIT  % ∆ sales  DOL.

so New EBIT = $25,000  ($25,000  150%)  $62,500.

Now, DTL = %∆ EPS %∆ in sales = %∆ common earnings %∆ in sales because outstanding

P13-18 Personal finance: Capital structures (LG 3; Intermediate)

Kirsten’s ratio is less than the bank maximum of 28%.

32.8%.

c. Kirsten’s ratios are below the bank maximums, so her loan application should be approved.

P13-19Various capital structures (LG 3; Basic)

Debt Ratio Debt Equity

10% $100,000 $900,000

20% $200,000 $800,000

Theoretically, the debt ratio cannot exceed 100%. Practically, few creditors would extend loans

P13-20 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

Less: Fixed costs 75,000 75,000 75,000

b. EPS:

Earnings after taxes $(16,200) $ 1,800 $ 19,800

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

Less: Interest 0 0 0

d. Summary statistics:

With Debt All Equity Including debt in Tower Interiors’ capital

structure produces a lower expected EPS, a higher

Expected

P13-21 EPS and optimal debt ratio (LG 4; Intermediate)

a. Maximum EPS appears to be at 60%

b. Debt

Ratio CV

0% 0.5

20 0.6

40 0.8

60 1.0

80 1.5

P13-22 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

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

Financial breakeven points:

Structure A Structure B

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

b and c. If EBIT is expected to fall below

$52,000, Structure A is preferred and

if EBIT is expected to top $52,000,

Structure B is preferred.

Note: This holds true whether the tax rate is 40% or 21%. The graph corresponds to a 40%

EBIT (because taxes are lower), but they intersect at the same EBIT regardless of the tax rate.

d. Structure A offers less risk and lower returns as EBIT increases; structure B has more risk

because of its higher financial breakeven point. The steeper slope of the line for Structure B

e. If EBIT is greater than $75,000, Structure B should be recommended because changes in EPS

are much greater for given values of EBIT. Note: Again, this conclusion holds regardless of

the tax rate.

P13-23 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

EPS (8,000 shares) $ 1.125 $ 2.625

EPS (10,000 shares) $ 1.08 $ 2.28

c. Structure A has greater financial leverage, hence greater financial risk.

d. If EBIT is expected to be below $27,000, Structure B is preferred. If EBIT is expected to be

e. If EBIT is expected to be $35,000, Structure A is recommended since changes in EPS are

P13-24 Integrative: Optimal capital structure (LG 3, 4, 6; Intermediate)

Debt Ratio 0% 15% 30% 45% 60%

EBIT $2,000,0

00 $2,000,0

Less: Interest

0 120,0

00 270,0

00 540,0

00 900,0

Profits available to

common stock $1,000,0

00 $

928,000 $

838,000 $

676,000 $

460,000

b. Estimated share price (Po) = EPS required return on common stock (rs)

Debt: 0% Debt: 15% Debt: 60%

c. The optimal capital structure would be 30% debt and 70% equity because this debt/equity mix

maximizes the price of the common stock.