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Chapter 14: Capital Structure and Leverage
Learning Objectives
371
Chapter 14
Capital Structure and Leverage
Learning Objectives
After reading this chapter, students should be able to:
◆ Explain why there may be differences in a firm’s capital structure when measured on a book-value
basis, a market-value basis, or a target basis.
372
Lecture Suggestions
Chapter 14: Capital Structure and Leverage
Lecture Suggestions
This chapter is rather long, but it is also modular, hence sections can be omitted without loss of
continuity. Therefore, if you are experiencing a time crunch, you could skip selected sections.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case
DAYS ON CHAPTER: 3 OF 56 DAYS (50-minute periods)
Chapter 14: Capital Structure and Leverage
Answers and Solutions
373
Answers to End-of-Chapter Questions
14-1 Operating leverage is the extent to which fixed costs are used in a firm’s operations. If operating
14-4 An increase in the personal tax rate makes both stocks and bonds less attractive to investors
because it raises the tax paid on dividend and interest income. Changes in personal tax rates will
b. An increase in the personal tax rate would cause investors to shift from bonds to stocks due
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Answers and Solutions
Chapter 14: Capital Structure and Leverage
14-6 Biotechnology companies use relatively little debt because their industries tend to be cyclical,
14-7 EBIT depends on sales and operating costs that generally are not affected by the firm’s use of
14-8 Expected EPS is generally measured as EPS for the coming years, and we typically do not reflect
in this calculation any bankruptcy-related costs. Also, EPS does not reflect (in a major way) the
14-9 The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s
14-10 With increased competition after the breakup of AT&T, the new AT&T and the seven Bell
operating companies’ business risk increased. With this component of total company risk
14-11 The firm may want to assess the asset investment and financing decisions jointly. For instance,
Chapter 14: Capital Structure and Leverage
Answers and Solutions
375
Solutions to End-of-Chapter Problems
14-2 The optimal capital structure is that capital structure where WACC is minimized and stock price is
14-3 a. Expected EPS for Firm C:
b. According to the standard deviations of EPS, Firm B is the least risky, while C is the riskiest.
14-4 From the Hamada equation, b = bU[1 + (1 – T)(D/E)], we can calculate bU as bU = b/[1 + (1 – T)(D/E)].
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Answers and Solutions
Chapter 14: Capital Structure and Leverage
)TEBIT(1−
b. LL: Debt/Capital = 30%.
EBIT $4,000,000
c. LL: Debt/Capital = 60%.
EBIT $4,000,000
Chapter 14: Capital Structure and Leverage
Answers and Solutions
377
b. QBE =
V P
F
−
=
$10
$140,000
= 14,000 units.
c. If the selling price rises to $31, while the variable cost per unit remains fixed, P – V rises to
$16. The end result is that the break-even point is lowered.
d. If the selling price rises to $31 and the variable cost per unit rises to $23, P – V falls to $8.
The end result is that the break-even point increases.
Dollars
800,000
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Answers and Solutions
Chapter 14: Capital Structure and Leverage
The break-even point increases to 17,500 units because the contribution margin per each
unit sold has decreased.
14-7 No leverage: Debt = 0; Equity = $14,000,000.
State
Ps
EBIT
(EBIT – rdD)(1 – T)
ROES
PS(ROE)
PS(ROES – RÔE)2
1
0.2
$4,200,000
$2,520,000
0.18
0.036
0.00113
RÔE = 10.5%.
Sales
Dollars
800,000
Chapter 14: Capital Structure and Leverage
Answers and Solutions
379
Debt/Capital = 50%: Debt = $7,000,000; Equity = $7,000,000; rd = 11%.
State
Ps
EBIT
(EBIT – rdD)(1 – T)
ROES
PS(ROE)
PS(ROES – RÔE)2
Step 1: Determine the firm’s current beta.
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Answers and Solutions
Chapter 14: Capital Structure and Leverage
Step 3: Determine the firm’s beta under the new capital structure.
14-9 a. Dividends = 0.4 × $1,000,000 = $400,000. So, the current dividend per share, D0, =
b. Step 1: Calculate EBIT before the recapitalization:
14-10 a. Firm A
1. Fixed costs = $80,000.
Chapter 14: Capital Structure and Leverage
Answers and Solutions
381
Firm B
1. Fixed costs = $120,000.
Check:
14-11 a. Using the standard formula for the weighted average cost of capital, we find:
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Answers and Solutions
Chapter 14: Capital Structure and Leverage
c. To “unlever” the firm's beta, the Hamada equation is used.
bL = bU[1 + (1 – T)(D/E)]
d. To determine the firm’s new cost of common equity, one must find the firm’s new beta under
its new capital structure. Consequently, you must “relever” the firm's beta using the Hamada
e. Again, the standard formula for the weighted average cost of capital is used. Remember, the
14-12 a. Without new investment:
Chapter 14: Capital Structure and Leverage
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1. EPSOld = $489,600/240,000 = $2.04.
With new investment:
Debt Stock
Sales $12,960,000 $12,960,000
b. EPS =
N
T) I)(1 F VC (Sales −−−−
Therefore,
)(0.6)$2,184,000 Q($10.667 −
)(0.6)$2,904,000 Q(10.667 −
0.6)$384,000)( $1,560,000 Q$22.667 Q($28.8 −−−
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Answers and Solutions
Chapter 14: Capital Structure and Leverage
d. At the expected sales level, 450,000 units, we have these EPS values:
Chapter 14: Capital Structure and Leverage
Answers and Solutions
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14-13 Use of debt (millions of dollars):
Probability 0.3 0.4 0.3
Sales $2,250.00 $2,700.00 $3,150.00
Use of stock (millions of dollars):
Probability 0.3 0.4 0.3
Sales $2,250.00 $2,700.00 $3,150.00
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Answers and Solutions
Chapter 14: Capital Structure and Leverage
Chapter 14: Capital Structure and Leverage
Comprehensive/Spreadsheet Problem
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Comprehensive/Spreadsheet Problem
Note to Instructors:
The solution to this problem is not provided to students at the back of their text. Instructors
can access the
Excel
file on the textbook’s website.
14-14 Tax rate = 40%; rRF = 5.0%; bU = 1.2; rM – rRF = 6.0%
From data given in the problem and table we can develop the following table:
Levered
wd wc D/E rd rd(1 – T) betaa rsb WACCc
d.
35%
Capital Costs Vs. D/(D+E)
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Comprehensive/Spreadsheet Problem
Chapter 14: Capital Structure and Leverage
35%
Capital Costs Vs. D/E
