“1 Problems ‘Chapter 14 Capital Structure and Leverage A firm is about to double its assets to serve its rapidly growing market. It must choose between a highly automated production process and a less automated one. It also must choose a capital structure for financing the expansion. Should the asset investment and financing decisions be jointly determined, or should each decision be made separately? How would these decisions affect one another? How could the leverage concept be used to help management analyze the situation? Easy 44 Problems 15 142 143 144 145 BREAK-EVEN ANALYSIS A company’s fixed operating costs are $430,000, its variable costs are $295 per unit, and the product's sales price is $450. What is the company’s breakeven point; that is, at what unit sales volume will its income equal its costs? ‘OPTIMAL CAPITAL STRUCTURE Terrell Trucking Company is in the process of setting its target capital structure. The CFO believes that the optimal debt-to-capital ratio is some- ‘where between 20% and 50%, and her staff has compiled the following projections for EPS and the stock price at various debt levels: Debuicapital Projected Projected Stock Ratio Ea Price 20% 0 Bas 20 355 2600 ‘0 370 3550 50 355 2400 ‘Assuming that the firm uses only debt and common equity, what is Terrell's optimal capital structure? At what debt-to-capital ratio is the company’s WACC minimized? RISK ANALYSIS 4. Given the following information, calculate the expected value for Firm C’s EPS, Data for Firms A and B are as follows: F(EPS,) = $5.10, ¢, = $31, F(EPS,) = $4.20, and 9, = $296. Probability 04 020402 Fimaces, (S150, —«G18O—«GSIO.—«SBAO—«STT7O FirmB:ePS, (120) 150 420« «90960 Fimces, 240) 135 S10 Bas b. You are given that ¢, = $4.11, Discuss the relative riskiness ofthe three firms’ earnings. UNLEVERED BETA Hartman Motors has $18 million in assets, which were financed with, {$6 million of debt and $12 million in equity. Hartman's beta is currently 13, and its tax rate is 35%. Use the Hamada equation to find Hartmans unlevered beta, b,. FINANCIAL LEVERAGE EFFECTS Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $20 million in invested capital, has $4 million of EBIT, and is in the 40% federal-plus-state tax bracket, Firm HL, hhowever, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LI. hhas a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure, {Calculate the return on invested capital (ROIC) for each firm, b. Calculate the return on equity (ROE) for each firm. 509510 Part 5 Capital Structure and Dividend Policy Intermediate Problems 69 Challenging Problems 10-13 et copy nn ti tm ye a pl ae pce a Bar ea ee eee 146 147 149 14-10 . Observing that HL has a higher ROE, LL’s treasurer is thinking of rising the debt-o- capital ratio from 30% to 60% even though that would increase L's interest rate on all debt to 15%, Calculate the new ROE for LL. BREAK-EVEN ANALYSIS The Warren Watch Company sells watches for $26, fixed costs are $155,000, and variable costs are $13 per watch, 1, What isthe firm’s gain or loss at sales of 9,000 watches? At 15,000 watches? bb. What isthe break-even point? Illustrate by means ofa chart «What would happen fo he break-even pont if the ein price was ised to S33? What is the significance of this analysis? dd. What would happen to the break-even point ifthe selling price was raised to $33 but variable costs rose to $24 a unit? FINANCIAL LEVERAGE EFFECTS. The Neal Company wants to estimate next year's return ‘on equity (ROE) under different financial leverage ratios. Neal's otal capital is $14 million, {currently uses only common equity, it has no future plans o use prefered stock in its capital structure, and its federalphusstate tax rate is 40%. The CFO has estimated next Year's EBIT for three possible states of the world: $42 million with a 02 probability, $28 millon with a 05 probability, and $700,000 with a 03 probability. Calculate Neal’s ‘expected ROE, standard deviation, and coeicient of variation for each ofthe following ‘debt to-capital ratios; then evaluate the results Debticapital Interest Ratio Rate Oe = 10 * 50 " © “ HAMADA EQUATION. Situational Software Co. (SSC) is trying to establish its optimal, Capit stucture, Tl current capital structure consists of 23% debt and 73% uly; fowever the CEO believes thatthe im should use more deb. The rskiree re Ie the market rok premium, RPyrlo St; and the firms tax rate Ove Caren, S5Co5 cost of equly b 12%, whichis determined by the CAPM What would be SSC4 mated cont of equty Wit changed is caplal suture to 40% debt and ear equy? RECAPITALIZATION Tartan Industries currently has total capital equal to $4 milion, has zero debi, isin the 40% federal-plus-state tax bracket, has a net income of $1 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 200,000 shares of stock are outstanding, and the current WACC is 12.30% ‘The company is considering a recapitalization where it will issue $2 million in debt land use the proceeds to repurchase stock, Investment bankers have estimated that i the ‘company goes through with the recapitalization, its before-tax cost of debt will be 10% and its cost of equity will rise to 155%. 1, What isthe stock's current price per share (before the recapitalization)? b. Assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization? Assume that shares are repurchased at the price taleulated in part a BREAKEVEN AND OPERATING LEVERAGE 2. Given the following graphs, calculate the total fixed costs, variable costs per unit, and sales price for Firm A. Firm B's fixed costs are $120,000, its variable costs per unit are $4, and its sales price is $8 per unit. bb. Which firm has the higher operating leverage at any given level of sales? Explain. € At what sales level, in units, do both firms earn the same operating profit? i epic te th