P13-28 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
Case: “Evaluating Tampa Manufacturing’s Capital Structure”
Case studies are available on www.pearson.com/mylab/finance.
This case involves evaluating Tampa Manufacturing’s current and proposed capital structures in terms of
maximization of EPS and financial risk before recommending one. Students are challenged to go beyond the
numbers and consider the overall impact on the firm’s financial policies.
a. Times interest earned:
Current
10% Debt Alternative A
30% Debt Alternative B
50% Debt
Debt $1,000,000 $3,000,000 $5,000,000
Coupon rate 0.09 0.10 0.12
As the debt ratio increases from 10% to 50%, so do financial leverage and risk. At 10% debt,
EBIT is more than 13 times larger than interest payments, the firm still has 4 times coverage.
b. EBIT-EPS (using any two EBIT levels):
Current
10%
Debt
Alterna
tive A:
30%
Alternative B: 50% Debt 40,000 Shares
0 0
Taxes 204,0
00 444,
000 120,0
00 360
,000
0 240,
000
c. Given Tampa Manufacturing’s EBIT of $1,200,000, EPS is highest with the 50% debt ratio.
The steeper slope of the lines representing higher debt levels demonstrates financial leverage
d. Recall, share price can be estimated using: P0 EPS rs. So, current price: $6.66 0.12
e. Alternative A, 30% debt, appears to be the best alternative. Although EPS is higher with
Alternative B, the financial risk is high; times interest earned is only 2 times. Alternative A
Spreadsheet Exercise
Answers to Chapter 13’s Starstruck Company exercise on optimal capital structure are available on
www.pearson.com/mylab/finance.
Group Exercise
Group exercises are available on www.pearson.com/mylab/finance .
This chapter integrates leverage into valuation of the firm. Students will begin by retrieving the most recent
income statement of their shadow firm—focusing on measures related to leverage, such as EBI and
fixed/variable operating costs. Using this information, groups will assemble a similar income statement for
their fictitious firm. After assigning a per-unit price for their product, groups will calculate the operating