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CHAPTER 16
FINANCIAL LEVERAGE AND CAPITAL
STRUCTURE POLICY
Answers to Concepts Review and Critical Thinking Questions
1. Business risk is the equity risk arising from the nature of the firm’s operating activity and is directly
related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely
2. No, you cannot make this conclusion. While it is true that the equity and debt costs are rising, the
3. Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot
easily be identified or quantified, it’s practically impossible to determine the precise debt-equity ratio
4. The more capital-intensive industries, such as airlines, cable television, and electric utilities, tend to
use greater financial leverage. Also, industries with less predictable future earnings, such as
6. Since the interest expense is limited to 30 percent of EBIT, the minimum times interest earned ratio
7. One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts
8. As in the previous question, it could be argued that using bankruptcy laws as a sword may be the
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9. One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The
bankruptcy filing enabled Continental to restructure and keep flying. The other side is that
Continental abused the bankruptcy code. Rather than renegotiate labor agreements, Continental
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. a. A table outlining the income statement for the three possible states of the economy is shown
below. The EPS is the net income divided by the 5,500 shares outstanding. The last row shows
the percentage change in EPS the company will experience in a recession or an expansion
economy.
Recession Normal Expansion
EBIT $17,400 $29,000 $37,700
b. If the company undergoes the proposed recapitalization, it will repurchase:
Share price = Equity/Shares outstanding
Shares repurchased = Debt issued/Share price
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The interest payment each year under all three scenarios will be:
The last row shows the percentage change in EPS the company will experience in a recession
or an expansion economy under the proposed recapitalization.
Recession Normal Expansion
EBIT $17,400 $29,000 $37,700
2. a. A table outlining the income statement with taxes for the three possible states of the economy is
shown below. The share price is still $25, and there are still 7,400 shares outstanding. The last
row shows the percentage change in EPS the company will experience in a recession or an
expansion economy.
Recession Normal Expansion
EBIT $17,400 $29,000 $37,700
b. A table outlining the income statement with taxes for the three possible states of the economy
and assuming the company undertakes the proposed capitalization is shown below. The interest
payment and shares repurchased are the same as in part b of Problem 1.
Recession Normal Expansion
EBIT $17,400 $29,000 $37,700
Interest 4,550 4,550 4,550
Notice that the percentage change in EPS is the same both with and without taxes.
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3. a. Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the
market value of equity. Using the equation for ROE:
The ROE for each state of the economy under the current capital structure and no taxes is:
Recession Normal Expansion
The second row shows the percentage change in ROE from the normal economy.
b. If the company undertakes the proposed recapitalization, the new equity value will be:
So, the ROE for each state of the economy is:
Recession Normal Expansion
c. If there are corporate taxes and the company maintains its current capital structure, the ROE is:
If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE
for each state of the economy is:
Notice that the percentage change in ROE is the same as the percentage change in EPS. The
percentage change in ROE is also the same with or without taxes.
4. a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax.
The EPS under this capitalization will be:
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Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest
payment is the amount of debt times the interest rate, so:
And the EPS will be:
Plan I has the higher EPS when EBIT is $400,000.
b. Under Plan I, the net income is $600,000 and the EPS is:
Under Plan II, the net income is:
And the EPS is:
c. To find the break-even EBIT for two different capital structures, we set the equations for EPS
equal to each other and solve for EBIT. The break-even EBIT is:
5. We can find the price per share by dividing the amount of debt used to repurchase shares by the
number of shares repurchased. Doing so, we find the share price is:
The value of the company under the all-equity plan is:
And the value of the company under the levered plan is:
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6. a. The income statement for each capitalization plan is:
I II All-equity
EBIT $79,000 $79,000 $79,000
Plan II has the highest EPS; the all-equity plan has the lowest EPS.
b. The break-even level of EBIT occurs when the capitalization plans result in the same EPS. The
EPS is calculated as:
This equation calculates the interest payment (RDD) and subtracts it from the EBIT, which
results in the net income. Dividing by the shares outstanding gives us the EPS. For the all-
And the break-even EBIT between the all-equity capital structure and Plan II is:
The break-even levels of EBIT are the same because of M&M Proposition I.
c. Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT,
we get:
This break-even level of EBIT is the same as in part b again because of M&M Proposition I.
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d. The income statement for each capitalization plan with corporate income taxes is:
I II All-equity
EBIT $79,000 $79,000 $79,000
Plan II still has the highest EPS; the all-equity plan still has the lowest EPS.
We can calculate the EPS as:
This is similar to the equation we used before, except now we need to account for taxes. Again,
the interest expense term is zero in the all-equity capital structure. So, the break-even EBIT
between the all-equity plan and Plan I is:
The break-even EBIT between the all-equity plan and Plan II is:
And the break-even between Plan I and Plan II is:
The break-even levels of EBIT do not change because the addition of taxes reduces the income
of all three plans by the same percentage; therefore, they do not change relative to one another.
7. To find the value per share of the stock under each capitalization plan, we can calculate the price as
the value of shares repurchased divided by the number of shares repurchased. So, under Plan I, the
value per share is:
And under Plan II, the value per share is:
This shows that when there are no corporate taxes, the stockholder does not care about the capital
structure decision of the firm. This is M&M Proposition I without taxes.
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8. a. The earnings per share are:
So, the cash flow for the investor is:
b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under
the proposed capital structure. The market value of the firm is:
Under the proposed capital structure, the firm will raise new debt in the amount of:
This means the number of shares repurchased will be:
Under the new capital structure, the company will have to make an interest payment on the new
debt. The net income with the interest payment will be:
This means the EPS under the new capital structure will be:
Since all earnings are paid as dividends, the shareholder will receive:
c. To replicate the proposed capital structure, the shareholder should sell 30 percent of their
shares, or 30 shares, and lend the proceeds at 8 percent. The shareholder will have an interest
cash flow of:
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The shareholder will receive dividend payments on the remaining 70 shares, so the dividends
received will be:
The total cash flow for the shareholder under these assumptions will be:
This is the same cash flow we calculated in part a.
d. The capital structure is irrelevant because shareholders can create their own leverage or unlever
9. a. The rate of return earned will be the dividend yield. The company has debt, so it must make an
interest payment. The net income for the company is:
The investor will receive dividends in proportion to the percentage of the company’s shares
they own. The total dividends received by the shareholder will be:
So the return the shareholder expects is:
b. To generate exactly the same cash flows in the other company, the shareholder needs to match
The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC.
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The total cash flow for the shareholder will be:
The shareholder’s return in this case will be:
c. ABC is an all equity company, so:
To find the cost of equity for XYZ we need to use M&M Proposition II, so:
RE = RA + (RA – RD)(D/E)(1 – TC)
d. To find the WACC for each company we need to use the WACC equation:
WACC = (E/V)RE + (D/V)RD(1 – TC)
So, for ABC, the WACC is:
And for XYZ, the WACC is:
10. With no taxes, the value of an unlevered firm is the EBIT divided by the unlevered cost of equity, so:
V = EBIT/WACC
