Chapter 18 Capital Structure and the Cost of Capital CHAPTER PREVIEW There are templates for constructing cash budgets and formulas for computing financial ratios, effective borrowing costs, cash flows, NPV, IRR, and the like. But determining a firm’s capital structure defies formulas. Management must determine, given financing costs, financial market conditions, and internal firm conditions, the financing structure that minimizes the firm’s overall financial costs or its cost of capital. Doing so is a necessary condition to maximizing shareholder wealth. This chapter reviews some of the tools managers can use in the art of selecting a capital structure. Once the financing mix is selected, the firm’s cost of capital—the return it should earn on its average risk projects—can be determined. LEARNING OBJECTIVES • Explain how capital structure affects a firm’s capital budgeting discount rate. • Explain how a firm can determine its cost of debt financing and cost of equity financing. • Explain how a firm can estimate its cost of capital. • Explain how a firm’s growth potential, dividend policy, and capital structure are related. • Explain how EBIT/eps analysis can assist management in choosing a capital structure. • Describe how a firm’s business risk and operating leverage may affect its capital structure. • Describe how a firm’s degree of financial leverage and degree of combined leverage can be computed and explain how to interpret their values. • Describe the factors that affect a firm’s capital structure. CHAPTER OUTLINE I. WHY CHOOSE A CAPITAL STRUCTURE? A. Trends in Corporate Use of Debt II. REQUIRED RATE OF RETURN AND THE COST OF CAPITAL III. COST OF CAPITAL A. Cost of Debt B. Cost of Preferred Stock C. Cost of Common Equity 1. Cost of Retained Earnings: Security Market Line Approach 2. Cost of Retained Earnings: Constant Dividend Growth Model D. Cost of New Common Stock IV. WEIGHTED AVERAGE COST OF CAPITAL A. Capital Structure Weights B. Measuring the Target Weights C. What Do Businesses Use As Their Cost of Capital? IV. DIFFICULTY OF MAKING CAPITAL STRUCTURE DECISIONS VI. PLANNING GROWTH RATES A. Internal growth rate B. Sustainable Growth Rate C. Effects of Unexpectedly Higher (or Lower) Growth VII. EBIT/EPS ANALYSIS A. Indifference Level VIII. COMBINED OPERATING AND FINANCIAL LEVERAGE EFFECTS A. Unit Volume Variability B. Price-Variable Cost Margin C. Fixed Costs D. Degree of Financial Leverage E. Total Risk IX. INSIGHTS FROM THEORY AND PRACTICE A. Taxes And Nondebt Tax Shields B. Bankruptcy Costs C. Agency Costs D. A Firm’s Assets and Its Financing Policy E. The Pecking Order Hypothesis F. Market Timing G. Beyond Debt and Equity X. GUIDELINES FOR FINANCING STRATEGY A. Business Risk B. Taxes And Nondebt Tax Shields C. Mix of Tangible and Intangible Assets D. Financial Flexibility E. Control of the Firm F. Profitability G. Financial Market Conditions H. Management’s Attitude Toward Debt and Risk XI. SUMMARY LECTURE NOTES I. WHY CHOOSE A CAPITAL STRUCTURE? The important concept here goes back to our basic present value calculations in Chapters 9 and 10: expected returns and value (or interest rates and asset prices) move inversely. The optimal capital structure results in the minimum cost of capital, which is necessary to maximize shareholder wealth. Students may find the historical perspective on debt ratios of some interest. The generally rising-debt ratio shown in Figure 18.2 is consistent with a growing economy and the static-trade-off hypothesis. Two noticeable declines in the use of debt occurred since 1970: first, in the later 1970s when inflation rates and interest rates hit double digits (the prime rate peaked at 21 percent); and, second, in the late 1980s following the 1987 stock market crash. Fears of slower economic growth and bankruptcies lead firms to reduce their borrowing, although that trend has reversed itself as economic growth speeded up in the mid-1990s. Figure 18.3 is useful in illustrating the different levels of debt use among different-sized firms; Figure 18.6 shows debt levels by firms in different industries. (Use Discussion Questions 1 through 3 here.) II. REQUIRED RATE OF RETURN AND THE COST OF CAPITAL A project’s minimum required rate of return is not chosen subjectively like the payback period’s cutoff. The minimum rate of return is derived from current financial market data. We discuss three terms related to return on investment (required rate of return, cost of capital, and discount rate) because each views the same concept from a different perspective. Investors will not give funds to the firm unless they feel they will receive the required rate of return. The cost of capital is the cost to the firm of paying investors’ required returns. The appropriate discount rate is the number used to discount cash flows in a present value calculation. An important point to make is the use of a weighted average cost, not a project-specific cost, to evaluate a project’s affect on shareholder wealth. Financing low-return projects with the firm’s scarce debt capacity while turning down high-return equity financed projects will not result in shareholder wealth maximization over time. (Use Discussion Question 17 here.) III. COST OF CAPITAL The cost of capital concept has two important applications outside of capital budgeting. First, boards (sometimes called public utility commissions) which oversee regulated utilities set rates by allowing the utilities to earn a “fair” return on their capital. The cost of capital of the utilities is computed to determine the level of a “fair” return. The second application is the concept of Economic Value Added (EVA), which is related to the Market Value Added concept reviewed in Chapter 13. EVA is a year-by-year measure of managerial performance; it is roughly equal to EBIT minus the firm’s dollar cost of capital (which is the cost of capital multiplied by beginning capital). It considers the cost of capital and the amount of capital tied up in receivables, inventories, etc., which traditional, accounting-focused measures of periodic performance ignore. More importantly for managers, the EVA concept can be applied at the divisional or plant level by appropriately adjusting the dollar cost of capital. The main point of the discussion of financing costs is that current prices and interest rates need to be used in the analysis; past prices and rates do us little good today. The discussion here also relates to the Part 2 focus on investments. Here, corporate financial managers must use the information and theory (security market line) of the investment and financial markets to estimate their firm’s cost of capital. (Use Discussion Questions 18 through 21 here.) IV. WEIGHTED AVERAGE COST OF CAPITAL An important point to stress is that the weights used to compute the weighted average cost of capital are target weights corresponding to management’s estimate of the firm’s optimal capital structure. The weights are not necessarily the firm’s actual proportion of debt and equity. To compare the firm’s current capital structure weights with its target weights, financial theory stresses that market value weights should be used, not book value weights. In practice, many firms use book value weights because 1. They are not as variable as market values. 2. They are easier to compute (simply look at the latest balance sheet). 3. Management already uses book value numbers when evaluating debt ratios, as we reviewed in Chapter 14. (Use Discussion Questions 22 through 23 here.) V. DIFFICULTY IN MAKING CAPITAL STRUCTURE DECISIONS This short section prepares the student for the remainder of the chapter by discussing that, despite what they may believe from the course thus far, not everything in finance is formula-driven! A number of influences will affect management’s capital structure choices. We mention three: the firm’s growth rate, profitability, and dividend policy, which will be expanded upon in the next section. A review of Figure 18.3, Figure 18.6, and Table 18.1 may help start a discussion on how a firm’s characteristics affect capital structure. (Use Discussion Question 24 here.) VI. PLANNING GROWTH RATES The balance sheet equation, Assets = Liabilities + Equity, tells us that changes in the level of assets must be financed by liabilities (short-term or long-term debt) or equity (stock financing or additions to retained earnings). Management’s plans for growth are tied into its plans for financing growth. The internal growth rate calculation estimates the rate that assets can increase without tapping new outside funds: this growth rate is related to the firm’s profitability and its dividend policy. The sustainable growth rate assumes management wants to keep the firm’s debt ratios at their current level; any changes in equity (due to increases in retained earnings) will allow the firm to increase its borrowing to maintain constant (book value) debt ratios (namely, the equity multiplier, debt-to-assets, debt-to-equity). These simple models can lead to a discussion of what tools management has to control if actual growth differs from planned growth: dividend policy, pricing/expense factors (profitability) and capital structure. Thus far in the text, dividends have been something that investors receive; next we look at the role of dividends from the joint perspective of financial managers and investors. We intuitively discuss the dividend irrelevance theorem in a world without taxes and commissions and then review why, in the real world, firms chose to pay dividends rather than repurchase stock (investors like the income stream and the growth in income over time has been substantial) or reinvest the funds back into the firm. Here we tie in the discussion on agency concerns from chapter 13 and management’s ability to signal markets with dividend changes to explain why dividends are paid. To show the importance of dividends, we present recent international empirical evidence on over diversification by firms and investor protection environments and their consequences for dividend policy. Since funds paid as dividends can not be used by the firm to increase its equity base, dividend policy affects the firm’s external financing needs, capital structure strategy, and growth opportunities. (Use Discussion Questions 15 and 16 here.) VII. EBIT/EPS ANALYSIS EBIT/eps analysis is a simple tool to show the effect of a new capital structure on earnings. It has several drawbacks: 1. It does not incorporate risk measures or expected stock price reaction. Figure 18.8 shows the capital structure that maximizes earnings is not necessarily the one that maximizes firm value. This can be described by using the Price/Earnings stock valuation model, too: stock price = eps x P/E ratio. The market’s valuations of high-risk earnings will likely result in a lower P/E ratio although eps may rise as leverage rises. 2. It focuses on accounting earnings rather than cash flows. Still, it is a good first step to see the impact of a capital structure change on the firm. The use of scenarios helps students see the risk involved in financial leverage, as changing to a more leveraged capital structure will result in a more steeply sloped relationship between EBIT and eps, as seen in Figure 18.7. The indifference level shows the minimum EBIT needed so the firm is better off (in terms of eps) from a more highly levered capital structure. Managers can evaluate earnings forecasts and scenarios to evaluate the risk involved of earning the indifference level of EBIT. The variation in EBIT over time is a popular measure of business risk. You can ask students to think about where business risk comes from: operating leverage, sales variations, and variations in the firm’s price-variable cost margin over time as a lead-in to the next section. (Use Discussion Questions 4 and 5 here.) VIII. COMBINED OPERATING AND FINANCIAL LEVERAGE EFFECTS As we saw in Chapter 14, operating leverage affects the top part of a firm’s balance sheet; fixed operating costs lead EBIT to change by a larger percentage than sales. If there are no fixed operating costs, DOL is zero. Financial leverage affects the bottom half of the income statement. Interest expense causes eps to change by a larger percentage than EBIT. If there are no interest charges, DFL is zero. Try to get the students to intuitively think through the impact of a change in sales on eps. Combined leverage is the product of operating leverage and financial leverage. Practical uses of this concept include evaluating a firm’s capital structure policy as well as estimating a firm’s earnings from a sales forecast. This concept also helps to explain why, when the business cycle starts to turn upward, firms with large amounts of operating and/or financial leverage enjoy the largest earnings increases. (Use Discussion Questions 6 through 12 here.) IX. INSIGHTS FROM THEORY AND PRACTICE Several theories have been advanced to explain firm’s capital structure choices and empirical tests of these theories shed light on corporate practices and motivations. This section reviews the role of a number of theorized influences on capital structure: 1. Debt and nondebt tax shields: the tax-deductibility of debt interest, and incentives to use debt, have lesser effects if income variability or nondebt tax shields (depreciation, R&D, advertising) exist. 2. Bankruptcy costs: the static trade-off hypothesis states firms will balance the benefits (tax deductibility of interest) and the expected costs of bankruptcy (legal fees, management’s time, loss of employees who leave for more secure positions). Bond ratings are an indicator of bankruptcy or default risk. Figure 18.9 shows the effect of the trade-off on the cost of capital. 3. Agency costs: first introduced in Chapter 13, the existence of agency costs, like bankruptcy costs, will help to lower the firm’s use of debt. International evidence presents evidence of the importance of agency costs to debt and equity holders in affecting capital structure decisions. 4. Types of assets: related to bankruptcy and agency costs, the type of assets a firm has will influence its capital structure. Tangible assets can support higher levels of debt financing than intangible assets (management skill, R&D, etc.) 5. Pecking Order: management does not want to issue new equity because of its higher cost and dilutive effects. They would rather a) use retained earnings, then b) issue debt to finance growth. If true, firms have no optimal debt ratio and a firm’s current debt load is the result of past uses of the firm’s financing pecking order. Higher profit firms, because of their ability to increase retained earnings, will have lower debt ratios than lower-profit firms; this is opposite what the static trade-off hypothesis suggests. Empirical evidence finds in favor of the pecking order hypothesis on this point. 6. Market Timing: Firms prefer to issue equity when market optimism and expectations give the firm’s shares a high price; they prefer to repurchase shares when stock prices are low. The firm’s capital structure is a result of past market timing decisions to time the financial markets. Many of these perspectives make intuitive sense and have some empirical backing. Taken together, they suggest management considers many factors when deciding to issue new securities to finance growth. A concern to some students may be the implication that the pecking order and market timing theories imply that there is no theoretically correct “capital structure” for a firm. Even if this is so, management must still make a decision, as the financial markets will be wary of firms with excessive financial risk or little financial flexibility. Excessive risk will result in lower stock prices and firm values. Too little use of debt may make the firm a takeover target in the market for corporate control. Imaginative Wall Street investment bankers and “rocket scientists” have developed many different security innovations. Useful references include Kenneth A. Carow, Gayle Erwin, and John McConnell, “A Survey of U.S. Corporate Financing Innovations: 1970-1997”, Journal of Applied Corporate Finance, Vol 12, No 1 (1999), pp. 55-69; John D. Finnerty “Financial Engineering in Corporate Finance: An Overview,” Financial Management, Winter 1988, pp. 14–33 and John D. Finnerty, “An Overview of Corporate Securities Innovation,” The New Corporate Finance, D. H. Chew, Jr., ed., New York, NY: McGraw-Hill, 1993. Variations in bonds, preferred stock, and common stock exist with regard to maturity, cash flows, voting rights, callability, putability, and convertibility. (Use Discussion Questions 25 through 29 here.) X. GUIDELINES FOR FINANCING STRATEGY 1. Business Risk: As firms in the same industry face similar business risks, some comparison to rival’s financing strategies is appropriate. Lower levels of business risk should allow for greater relative use of debt. 2. Taxes and Nondebt Tax Shield: Interest deductibility provides an incentive to use debt, subject to the presence of nondebt tax shields. 3. Mix of Tangible and Intangible Assets: This mix has bankruptcy cost and agency cost implications. Debt is less attractive for financing intangibles and growth opportunities. 4. Financial Flexibility: Firms like to maintain some unused debt capacity so they can raise funds should attractive opportunities arise or should they run short of cash. Unused debt capacity also gives the firm the choice of issuing debt or equity; it will not be forced to issue equity at an inopportune time. 5. Maturity Matching: Use of debt or leases can lead to matching a firm’s need or exposure to a project/joint venture with the maturity of a financing source. Equity has no maturity, although corporate resources can be used to repurchase it; allowing debt to mature is more automatic. 6. Corporate Control: All else being equal, current shareholders prefer to maintain ownership control of the firm. They may prefer debt financing to additional equity financing to avoid earnings and control dilution. 7. Profitability: Higher profits can mean greater reliance on additions to retained earnings to finance growth. 8. Timing and Financial Market Conditions: Security issues depend upon the level and expectations for short-term and long-term interest rates as well as stock prices. 9. Management’s Attitude toward Debt and Risk: Some people are more risk-averse than others. Expectations of future growth and profitability will affect the capital structure decision. (Use Discussion Questions 13 and 14 here.) DISCUSSION QUESTIONS AND ANSWERS 1. What is a firm’s capital structure? Capital structure is the mix of a firm’s long-term debt and equity. 2. Explain why determining a firm’s optimum debt/equity mix is important. Expected returns and value (or interest rates and asset prices) move inversely. The optimal capital structure results in the minimum cost of capital, which is necessary to maximize shareholder wealth. 3. Briefly describe the trends that have occurred in the corporate use of debt. The generally rising debt ratio shown in Figure 18.2 is consistent with a growing economy. Two noticeable declines in the use of debt occurred since 1960: first, in the later 1970s when inflation rates and interest rates hit double digits (the prime rate peaked at 21 percent); and, second, in the late 1980s following the 1987 stock market crash. Fears of slower economic growth and bankruptcies lead firms to reduce their borrowing, although that trend has reversed itself as economic growth speeded up in the mid-1990s. Following the turn of the century, the use of debt moderated due to 9/11 and more moderate corporate growth. 4. What is EBIT/eps analysis? What information does it provide managers? EBIT/eps analysis allows managers to see how different capital structures affect the earnings levels of their firms under different scenarios. 5. Describe the term “indifference level” in conjunction with EBIT/eps analysis. The indifference level is the level of EBIT at which the EBIT/eps lines cross. At this point, the firm will be indifferent between the two capital structures, insomuch as the eps of each are the same. 6. Describe how a firm’s business risk can be measured and indicate how operating leverage impacts on business risk. Business risk is measured by the variability of EBIT over time. Larger fixed operating costs leads to a higher degree of operating leverage and, all else constant, higher levels of business risk. 7. How is financial leverage created? Describe how the degree of financial leverage is calculated. Financial leverage arises from interest expense; in other words, having debt in the capital structure. 8. Briefly explain the concepts of business risk, operating leverage, and financial leverage in terms of an income statement. Business risk is seen in the variability of EBIT over time. One of the sources of business risk is operating leverage, or fixed costs in the firm’s operating structure. Operating leverage affects the top half of a firm’s income statement, leveraging a percentage change in sales to a larger percentage change in EBIT. Financial leverage arises from interest expenses and affects the bottom half of a firm’s income statement. It leverages a percentage change in EBIT to a larger percentage change in eps. 9. How might the following influences affect a firm’s business risk (consider each separately)? a. Imports increase the level of competition b. Labor costs decline c. Health care costs (provided for all employees) increase d. The firm’s proportion of social security and unemployment insurance taxes rises e. Adoption of new technology allows the firm to produce the same output with the fewer employees a. Higher levels of competition will lead to pressure to lower prices, thus lowering EBIT and increasing DOL. b. Lower costs will lead to wider price-variable cost margins and higher levels of EBIT and lowering DOL. c. Higher costs will lead to narrower price-variable cost margins, lower levels of EBIT and higher levels of DOL. d. As a component of labor costs, these tax increases will increase labor costs, narrow the price-variable cost difference, decrease EBIT, and raise DOL. e. Variable costs, in the form of labor costs, will fall. But the net effect on business risk depends on the technology’s impact on fixed costs. 10. How might the following influences affect a firm’s financial risk (consider each separately)? a. Interest rates on the firm’s short-term bank loans are reduced b. The firm refinances a mortgage on one of its buildings at a lower interest rate c. Tax rates decline d. The firm’s stock price rises e. The firm suffers a sales and operating income decline a. Lower short-term interest rates will reduce the firm’s interest expense and reduce its financial risk. b. Lower long-term interest rates will reduce the firm’s interest expense and reduce its financial risk. c. Tax rates do not affect a firm’s financial risk. DFL equals EBIT/(EBIT-I). d. The firm’s stock price does not affect a firm’s financial risk. e. This will not affect financial risk, although the lower level of EBIT will imply a lower level of net income and earnings per share. 11. What is meant by the degree of combined leverage? Degree of combined leverage (DCL) is the combined effect of operating and financial leverage. It equals the percentage change in eps divided by the percentage change in sales. 12. Describe how the degree of combined leverage can be determined by the degrees of operating and financial leverage. DCL equals the product of degree of operating leverage (DOL) and degree of financial leverage (DFL). 13. Briefly explain how the factors of flexibility and timing affect the mix between debt and equity capital. Firms like to maintain some unused debt capacity so they can raise funds should attractive opportunities arise or should they run short of cash. Unused debt capacity also gives the firm the choice of issuing debt or equity; it will not be forced to issue equity at an inopportune time. This also relates to timing. Firms prefer to issue debt when interest rates are low and equity when stock prices are high. 14. How do corporate control concerns affect a firm’s capital structure? All else equal, current shareholders prefer to maintain ownership control of the firm. They may prefer debt financing to additional equity financing so they can maintain their proportionate ownership, voting rights, and claim on dividends. 15. The management of Albar Incorporate has decided to increase the firm’s use of debt form 30 percent to 45 percent of assets. How will this affect its internal growth rate in the future? Its sustainable growth rate? The internal growth rate is determined by the firm’s return on assets and retention rate, so there is no direct impact of the leverage increase on the internal growth rate (except for effects from increased interest expense lowering net income and ROA). The effect of the financial leverage increase will be most directly seen in the firm’s sustainable growth rate. ROE is directly impacted by changes in the equity multiplier, which will increase as the ratio of debt to assets rises. 16. A booming economy creates an unexpectedly high sales growth rate for a firm with a low internal growth rate. How can the firm respond to this unplanned sales increase? The sales increase will strain the firm’s assets. Increases in receivables and inventory will likely occur and additional fixed assets may be needed. The firm can do one or a combination of the following three strategies to finance the increase in assets: increase profitability (increase prices or lower costs); reduce the dividend to increase additions to retained earnings; seek additional outside financing via new debt or equity issues. 17. What is the relationship between a firms' cost of capital and investor required rates of return? They are identical. The cost of capital is a weighted average of investors’ required rates of return. It represents the minimum rate of return a project can earn and still satisfy investors’ expectations. 18. How can a firm estimate its cost of debt financing? A firm can determine its cost of debt by several methods. If the firm targets an “A” rating (or any other bond rating), a review of the yields to maturity on A-rated bonds in Standard & Poor’s Bond Guide can provide an estimate of the firm’s current borrowing costs. It is important to examine bonds whose ratings and characteristics resemble those the firm wants to match. In addition, the firm can solicit the advice of investment bankers on the cost of issuing new debt. Or, if the firm has debt currently trading, it can use public market prices and yields to estimate its current cost of debt. Finally, a firm can seek long-term debt financing from a bank or a consortium of banks. Preliminary discussions with the bankers will indicate a ballpark interest rate the firm can expect to pay on its borrowing. 19. Describe how the cost of preferred stock is determined. The cost of preferred stock is the preferred stock dividend divided by the net proceeds the firm receives from selling the stock. The net proceeds equal the price of the preferred stock minus flotation costs. 20. Describe two methods for estimating the cost of retained earnings. The cost of retained earnings can be estimated using the SML approach or the constant dividend growth model. Under the SML approach, the security market line equation gives the firm’s cost of equity capital based upon the stock’s beta, the risk-free rate, and the expected market risk premium. If the constant dividend growth model is used, the required return equals the next year’s dividend yield plus the growth rate. 21. How does the cost of new common stock differ from the cost of retained earnings? These two costs differ because of the flotation costs associated with issuing new common stock. 22. What is the weighted average cost of capital? Describe how it is calculated. The weighted average cost of capital represents the minimum required rate of return on a capital budgeting project. It is computed by summing the product of each financing source’s cost with its target capital structure weight. 23. Should book value weights or market value weights be used to evaluate a firm’s current capital structure weights? Why? Financial theory favors the use of market value weights. Current market values are used to compute the cost of each financing source; market-based costs should be weighted using market-determined weights. 24. How does management’s strategy toward corporate growth and dividends affect its capital structure policy? A desire to grow more quickly, with a given dividend policy and level of profitability, means the firm will have to seek additional outside financing. The sustainable growth rate model assumes growth is financed by additions to debt and additions to retained earnings. Of course, management may choose a different financing mix when it taps external financial markets. 25. If a firm is eligible to receive tax credits, how might that affect its use of debt? Tax credits will lower the firm’s tax bill and thus reduce the tax incentive effect from tax-deductible interest payments. Thus, if all else is constant, we expect such firms to use relative less debt and relatively more equity financing. 26. Describe the reasoning behind the static tradeoff hypothesis. The static tradeoff hypothesis states that firms will balance the advantages of debt (its lower cost and tax-deductibility of interest) with its disadvantages (greater possibility of bankruptcy and the value of explicit and implicit bankruptcy costs). At low levels of debt, increasing the use of debt is beneficial as debt’s lower cost helps to lower the weighted average cost of capital and to increase firm value. But further increases in debt beyond the optimal capital structure level actually reduce firm value, as investors' perceptions of the increased cost of bankruptcy outweigh the tax benefits of additional debt. 27. How do agency costs affect a firm’s optimal capital structure? How can differences in agency costs explain capital structure differences across countries? Explicit and implicit agency costs will increase the cost of external financing. In the case of debt, lack of oversight of management’s actions may lead debt holders to place restrictive covenants on management. Such agency costs will reduce the incentive to use debt financing. Studies have found that firms in countries with tighter security regulations and accounting standards, all of which help to reduce the agency costs of equity, use relatively more equity financing. Firms use relatively more debt financing in countries with lower debt agency costs. Actions which reduce the agency costs of debt include closer supervision by banks of their loans, existence of banks or a consortium of banks to meet most of a firm’s borrowing needs, and regulations that allow banks to own stock in firms and to sit on their corporate boards. 28. How do you expect the capital structures of two firms to differ if one is involved in steel production and the other does designs software to solve business problems? A steel firm will own tangible assets involved in steel production. A software firm’s assets that will most affect its value will be mainly intangible, namely the programming and business expertise of its employees. Lenders are more willing to lend money against “hard” assets since they can be claimed and resold in case of default. The steel firm will likely have a greater proportion of the book value of its assets financed by debt than the software company. 29. What implications might the pecking order and market-timing hypotheses have for an optimal capital structure? Is the weighted average cost of capital still an important concept under these hypotheses? The pecking order hypothesis (firms prefer to finance growth with additions to retained earnings, then debt, then new equity issues) and market timing hypothesis (sell new equity when stock prices are high, repurchase when stock prices are low) imply that a firm’s current capital structure is the sum total of past financing decisions—by following a pecking order in the face of growth needs or the firm’s success (or lack thereof) in timing the equity markets. At first look, there is no theoretically optimal capital structure. But this is not quite true. The market (investors) will still review a firm’s risk and return potential. Firms that have excessive levels of debt will receive lower bond ratings and will have lower stock prices, all else the same, than firms that have less leverage. Even if the pecking order or market timing views are correct, a firm may still find itself with too much debt that needs to be reduced. Similarly, if its debt levels are considered to be too low, it may become the target of a takeover attempt by an investor who is willing to increase its debt in order to pay for the takeover The weighted average cost of capital represents the minimum required return on a firm’s average-risk capital budgeting projects. The target capital structure weights reflect management's impression of a capital structure that is sustainable in the long run and that allows for financing flexibility over time. The cost of capital calculation is paramount; should a firm fail to earn an appropriate return on its capital budgeting projects, shareholder wealth and firm value will decline. Yes, even if pecking order or market timing perspectives are correct, the weighted average cost of capital still is a relevant concept. PROBLEMS AND ANSWERS 1. AQ&Q has EBIT of $2 million, total assets of $10 million, stockholders’ equity of $4 million, and pretax interest expense of 10 percent. a. What is AQ&Q’s indifference level of EBIT? Indifference EBIT level = (.10)($10 million) = $1 million b. Given its current situation, might it benefit from increasing or decreasing its use of debt? Explain. Current EBIT = $2 million > $1 million; increasing financial leverage is beneficial c. Suppose we are told AQ&Q’s average tax rate is 40 percent. How does this affect your answers to Parts a and b? No effect, as EBIT/TA > 10% interest cost 2. URA, Incorporated, has operating income of $5 million, total assets of $45 million, outstanding debt of $20 million, and annual interest expense of $3 million. a. What is URA’s indifference level of EBIT? Indifference EBIT level = ($3 million/$20 million)($45 million) = $6.75 million b. Given its current situation, might URA benefit from increasing or decreasing its use of debt? Explain. Current EBIT = $5 million < $6.75 million; decreasing financial leverage is beneficial c. Suppose forecasted net income is $4 million next year. If it has a 40 percent average tax rate, what will be its expected level of EBIT? Will this forecast change your answer to Part b? Why or why not? EBT = NI/(l – T) = $4 million/(1 – .4) = $6.67 million EBIT = EBIT + I = $6.67 million + 3 million = $9.67 million As this level of EBIT exceeds the indifference level, increasing the use of debt may now be beneficial. 3. Stern’s Stews, Inc., is considering a new capital structure. Its current and proposed capital structure follows: CURRENT AND PROPOSED CAPITAL STRUCTURES FOR STERN’S STEWS, INC. CURRENT PROPOSED Total assets $150 million $150 million Debt 25 million 100 million Equity 125 million 50 million Common stock price $ 50 $ 50 Number of shares 2,500,000 1,000,000 Interest rate 12% 12% Stern’s Stews’ president expects next year’s EBIT to be $20 million, but it may be 25 percent higher or lower. Ignoring taxes, perform an EBIT/eps analysis. What is the indifference level of EBIT? Should Stern’s Stews change its capital structure? Why or why not? Current –25% Expected + 25% EBIT $15 million $20 million $25 million –I 3 million 3 million 3 million NI $12 million $17 million $22 million eps $4.80 $6.80 $8.80 Proposed –25% Expected + 25% EBIT $15 million $20 million $25 million –I 12 million 12 million 12 million NI $ 3 million $ 8 million $13 million eps $ 3.00 $ 8.00 $13.00 Indifference level: EBIT – 3 = EBIT – 12 2.5 1.0 Indifference level of EBIT is $18 million. At the expected EBIT level, eps is higher under the proposed plan. But the indifference level falls within the 25% error range. 4. Faulkner’s Fine Fries, Inc. (FFF) is thinking about reducing its debt burden. Given the information below and an expected EBIT of $50 million (plus or minus 10 percent) next year, should FFF change their capital structure? CURRENT AND PROPOSED CAPITAL STRUCTURES FOR FFF, INC. CURRENT PROPOSED Total assets $750 million $750 million Debt 450 million 300 million Equity 300 million 450 million Common stock price $ 30 $ 30 Number of shares 10,000,000 15,000,000 Interest rate 12% 12% Current –10% Expected +10% EBIT $45 $50 $55 –I 54 54 54 NI $–9 $–4 $ 1 eps $–0.90 $–0.40 $ 0.10 Proposed –10% Expected + 10% EBIT $45 $50 $55 –I 36 36 36 NI $ 9 $14 $19 eps $ 0.60 $ 0.93 $ 1.27 As earnings per share is higher for all three scenarios, it is beneficial for FFF to change their capital structure. 5. Redo Problem 4, assuming that the less leveraged capital structure will result in a borrowing cost of 10% and a common stock price of $40. Interest cost = .10($300 million) = $30 million Number of shares = $450 million/$40 per share = 11.25 million shares Proposed –10% Expected + 10% EBIT $45 $50 $55 –I 30 30 30 NI $15 $20 $25 eps $ 1.33 $ 1.78 $ 2.22 This makes the proposed capital structure appear even more beneficial. 6. A firm has sales of $10 million, variable costs of $4 million, fixed expenses of $1.5 million, interest costs of $2 million and has a 30 percent average tax rate. a. Compute its DOL, DFL, and DCL. Sales $10 million –VC 4 million –FC 1.5 million EBIT $4.5 million –I 2.0 million EBT $2.5 million –T .75 million NI $1.75 million DOL = (S – VC)/(S – VC – FC) = (10 – 4)/(4.5) = 1.33 DFL = EBIT/(EBIT – I) = 4.5/(4.5 – 2.0) = 1.8 DCL = 1.33 × 1.8 = 2.40 b. What will be the expected level of EBIT and net income if next year’s sales rise 10 percent? EBIT will rise 13.3%, 10% × 1.33, to $5.10 million NI will rise 24%, 10% × 2.4, to $2.17 million c. What will be the expected level of EBIT and net income if next year’s sales fall 20 percent? EBIT will fall 26.6%, –20% × 1.33, to $3.30 million NI will fall 48%, –20% × 2.4, to $0.91 million 7. The income statements for Genatron Manufacturing for 2010 and 2011 are listed in the text. Assuming one-half of the general and administrative expenses are fixed costs, estimate Genatron’s degree of operating leverage, degree of financial leverage, and degree of combined leverage in 2010 and 2011. 2010 2011 Sales $1,300,000 $1,500,000 – Variable costs* 985,000 1,125,000 – Fixed costs** 115,000 128,000 EBIT $ 200,000 $ 247,000 – Interest 45,000 57,000 EBT $ 155,000 $ 190,000 – Tax 62,000 76,000 NI $ 93,000 $ 114,000 * COGS, marketing expenses; one-half of G&A expense ** Depreciation and one-half of G&A expense 2010: DOL = ($1,300,000 – 985,000)/$200,000 = 1.575 DFL = $200,000/($200,000 – 45,000) = 1.29 DCL = 1.575 × 1.29 = 2.03 2011: DOL = ($1,500,000 – 1,125,000)/$247,000 = 1.52 DFL = $247,000/($247,000 – 57,000) = 1.30 DCL = 1.52 × 1.30 = 1.98 8. The Nutrex Corporation wants to calculate its weighted average cost of capital. Its target capital structure weights are 40 percent long-term debt and 60 percent common equity. The before-tax cost of debt is estimated to be 10 percent and the company is in the 40 percent tax bracket. The current risk-free interest rate is 8 percent on Treasury bills. The expected return on the market is 13 percent and the firm’s stock beta is 1.8 a. What is Nutrex’s cost of debt? kd = YTM (1 – T) = 10%(1 – .4) = 6% b. Estimate Nutrex’s expected return on common equity using the security market line. kre = RFR + beta (RMKT – RFR) = 8% + 1.8(13% – 8%) = 17% c. Calculate the after-tax weighted average cost of capital. WACC = .4(6%) + .6(17%) = 12.6% 9. The balance sheets for the Genatron Manufacturing Corporation for the years 2010 and 2011 are listed in the text. a. Calculate the weighted average cost of capital based on book value weights. Assume an after-tax cost of new debt of 8.63 percent and a cost of common equity of 16.5 percent. Using the most recent data (2011), we have: wd = $400,000/($400,000 + 300,000 + 50,000 + $120,000) = .46 we = 1 – .46 = .54 WACC = .46(8.63%) + .54(16.5%) = 12.88% b. The current market value of Genatron’s long-term debt is $350,000. The common stock price is $20 per share and there are 30,000 shares outstanding. Calculate the WACC using market value weights and the component capital costs in Part a. Total equity = $20 × 30,000 = $600,000 wd = $350,000/($350,000 + $600,000) = .37 we = 1 – .37 = .63 WACC = .37(8.63%) + .63(16.5%) = 13.59% c. Recalculate the WACC based on both book value and market value weights assuming that the before-tax cost of debt will be 18 percent, the company is in the 40 percent income tax bracket, and the after-tax cost of common equity capital is 21 percent. kd = 18%(1 – .4) = 10.8% ke = 21% Book value WACC = .46(10.8%) + .54(21%) = 16.31% Market value WACC = .37(10.8%) + .63(21%) = 17.23% 10. The Basic Biotech Corporation wants to determine its weighted average cost of capital. Its target capital structure weights are 50 percent long-term debt and 50 percent common equity. The before-tax cost of debt is estimated to be 10 percent and the company is in the 30 percent tax bracket. The current risk-free interest rate is 8 percent on Treasury bills. The after-tax cost of common equity capital is 14.5 percent. Calculate the after-tax weighted average cost of capital. kd = 10% (1 – .30) = 7% ke = 14.5% WACC .5(7%) + .5(14.5%) = 10.75% 11. Using various internet resources and information contained in this text to estimate the cost of debt, cost of retained earnings, the cost of new equity, and the weighted average cost of capital for the following firms: Walgreens, Microsoft, and ExxonMobil. As an approximation, use current book value ratios as estimates of their target capital structure weights. This is an application of the formulas in the chapter and the students’ skills in finding financial information. The specific answer will depend upon the market conditions when this problem is assigned. This is also a good “in-class” demonstration and application of the techniques in this chapter. 12. Through library or internet resources, find information regarding the sources of long-term financing for AT&T. What are the current market prices for their outstanding bonds and stock? Estimate their current market value weights. Estimate the cost of each financing source and assuming the current market value weights equal the firm’s target capital structure, estimate its weighted average cost of capital. This is an application of the formulas in the chapter and the students’ skills in finding financial information. The specific answer will depend upon the market conditions when this problem is assigned. This is also a good “in-class” demonstration and application of the techniques in this chapter. 13. Derive equation 18-8 for the internal growth rate. Let S = last year's sales revenue; A = last year's total assets; D = last year's total liabilities; E = last year's stockholder's equity; NI/S =the firm's (presumably constant) profit margin, the ratio of net income to sales; g = the firm's expected sales growth rate; RR = the firm's (presumably constant) retention ratio. Using these symbols and relationships you are familiar with, find the following answers: a. What will this year's net income equal? Denote this year’s sales as S0. With a growth rate of g, we have S0 = S (1 + g). This year’s net income, NI0, equals next year’s sales, S (1 + g), multiplied by the profit margin NI/S: NI0 = S (1 + g) (NI/S) = NI (1 + g). b. How much will be added to stockholder's equity this year? The addition to retained earnings is net income multiplied by the retention ratio: ΔRE = NI (1 + g) x RR c. What is this year's level of assets? This year’s assets (A1) will grow at the sales growth rate, g: A1 = A (1 + g) d. What is the change in assets between last year and this year? The change in assets is A1 – A = A (1 + g) – A = A g e. The change in assets computed in part (d) has to be financed. Assuming only internal financing is available, compute the firm's internal growth rate. (Hint: Set your answers to part (b) and (d) equal to each other, and solve for g.) With only internal equity, the change in assets will equal the change in equity (additions to retained earnings). A g = NI (1 + g) x RR multiplying through, we have A g = NI x RR + NI x g x RR Dividing both sides by A gives us: g = (NI/A) x RR + (NI/A) x g x RR Realizing (NI/A) equals return on assets (ROA), and grouping similar terms, we have: g (1 – ROA x RR) = ROA x RR Solving for g, we have the formula for the internal growth rate: g = (ROA x RR) / (1 – ROA x RR) 14. Using the same notation used in the previous problem, now assume that the firm will raise some funds externally in order to keep the firm's debt-to-equity (D/E) ratio constant. a. What will this year's net income equal? Denote this year’s sales as S0. With a growth rate of g, we have S0 = S (1 + g). This year’s net income, NI0, equals next year’s sales, S (1 + g), multiplied by the profit margin NI/S: NI0 = S (1 + g) (NI/S) = NI (1 + g). b. How much will be added to stockholder's equity this year? The addition to retained earnings is net income multiplied by the retention ratio: ΔRE = NI (1 + g) x RR c. If the D/E ratio remains constant, how much external debt can the firm raise this year? The answer to (b) gives the change in equity. With a constant D/E ratio, the change in debt will be ΔD = (D/E) x ΔE = (D/E) x NI (1 + g) x RR d. What is this year's level of assets? The change in assets is A1 – A = A (1 + g) – A = A g e. What is the change in assets between this year and the last? The change in assets is A1 – A = A (1 + g) – A = A g f. The change in assets computed in part (e) has to be financed. Assuming a constant debt-to-equity ratio, compute the firm's sustainable growth rate. (Hint: Add your answers to parts (b) and (c) together and set them equal to the solution to part (e); then solve for g.) The change in assets will equal the change in equity (additions to retained earnings) plus the change in debt, given the constraint that the D/E ratio is constant. We have A g =(D/E) x NI (1 + g) x RR + NI (1 + g) x RR Combining terms on the right-hand side, we have A g = NI (1 + g) x RR x [(D/E) + 1] Since (D/E )+ 1 = D/E + E/E = (D+E)/E = A/E, we have A g = NI (1 + g) x RR x (A/E) = (NI/E) x (1 + g) x RR x A Dividing both sides by A gives us: g = (NI/E) x (1 + g) x RR We know that (NI/E) equals return on equity (ROE), and multiplying through, we have: g = (ROE x RR) + (g x ROE x RR) Solving for g, we have the formula for the sustainable growth rate: g = (ROE x RR) / (1 – ROE x RR) 15. Below are items from recent financial statements from Moss and Mole Manufacturing (listed in text). a. Find M&MM's internal growth rate. The return on assets is $37,500/$192,000 = 0.1953 The addition to retained earnings is NI – Dividends so the retention rate is: ($37,500 - $18,750)/$37,500 = 0.5 Internal growth rate = (0.5 x 0.1953)/(1 - 0.5 x 0.1953) = 0.1082 or 10.82% b. Find their sustainable growth rate. The ROE is $37,500/$44,000 = 0.8523 Sustainable growth rate = (0.5 x 0.8523)/(1 – 0.5 x 0.8523) = 0.7426 = 74.26% 16. The following information is from the financial statements of Bagel’s Biscuits (in text) a. Find Bagel’s internal growth rate. The return on assets is $8.0/$134.9 = 0.0593 The addition to retained earnings is NI – Dividends so the retention rate is: $8.0 - $3.2)/$8.0 = 0.6 Internal growth rate = (0.6 x 0.0593)/(1 - 0.6 x 0.0593) = 0.0369 or 3.69% b. Compute Bagel’s sustainable growth rate. The ROE is $8.0/$51.7 = 0.1547 Sustainable growth rate = (0.6 x 0.1547)/(1 – 0.6 x 0.1547) = 0.1023 or 10.23% 17. Income statements for Mount Lewis Copy Centers for 2010 and 2011 appear below (in the text). a. Compute and interpret the degree of operating leverage, degree of financial leverage, and degree of combined leverage in 2010. Assume the components of the costs of good sold are all variable costs. DOL = (S – VC)/(S – VC – FC) = ($20,000 - $10,000)/($20,000 - $10,000 - $4,500) = 1.82 A 1 percentage point change in sales will result in a 1.82 percentage point change in EBIT. DFL = EBIT/(EBIT – I) = $5,500/($5,500 - $3,000) = 2.20 A 1 percentage point change in EBIT will result in a 2.20 percentage point change in net income. DCL = DOL x DFL = 1.82 x 2.20 = 4.00 A 1 percentage point change in sales will result in a 4.00 percentage point change in net income. b. Compute and interpret the degree of operating leverage, degree of financial leverage, and degree of combined leverage in 2011. Assume the components of the costs of good sold are all variable costs. DOL = (S – VC)/(S – VC – FC) = ($21,000 - $10,500)/($21,000 - $10,500 - $5,100) = 1.94 A 1 percentage point change in sales will result in a 1.94 percentage point change in EBIT. DFL = EBIT/(EBIT – I) = $5,400/($5,400 - $3,200) = 2.45 A 1 percentage point change in EBIT will result in a 2.45 percentage point change in net income. DCL = DOL x DFL = 1.94x 2.45 = 4.75 A 1 percentage point change in sales will result in a 4.75 percentage point change in net income. c. Why did these numbers change between 2010 and 2011? A 5-percent increase in sales and variable costs was offset by a 13.3-percent increase in fixed costs. The greater-than-proportionate increase in fixed costs increased DOL and reduced 2011’s EBIT. The lower EBIT amount, coupled with an increased in interest expense, increased DFL. The increases in DOL and DFL resulted in an increased DCL, too. 18. Using the income statements from the Mount Lewis Copy Centers for 2010 and 2011 in Problem 17, find the percentage change in sales, EBIT, and net income. Use them to compute the degree of operating leverage, financial leverage, and combined leverage. The percentage change in sales: ($21,000-20,000)/$20,000 = 5 percent The percentage change in EBIT: ($5,400 - $5,500)/$5,500 = -1.82 percent The percentage change in net income: ($1,540 - $1,750)/$1,750 = -12 percent DOL = (% change in EBIT)/(% change in sales) = -1.82%/5% = -0.364 DFL = (% change in net income)/% change in EBIT) = -12%/-1.82% = 6.59 DCL = DOL x DFL = -0.364 x 6.59 = -2.40 These answers make little practical sense; no firm would want an operating structure so that sales increases lead to lower profits. A reason for this nonsense result is that fixed operating costs and financing costs changed, swamping the profits. If fixed costs had remained at their original levels, year 2011 profitability would be Sales $21,000 -COGS 10,500 -Leases + depreciation 4,500 (year 2010 level) =EBIT $6,000 -Interest 3,000 (year 2010 level) =EBT $3,000 -Taxes (30%) 900 =Net income $2,100 Using these figures, the percentage change in sales is 5%; EBIT 9.09%; and net income 20%. The leverage calculations are DOL = 9.09%/5.0% = 1.82 DFL = 20.0%/9.09% = 2.20 DCL = 1.82 x 2.20 = 4.00 19. Here's a recent income statement from TC1 Telecommunications Services, Inc. (numbers are in millions) Sales $53.7 Costs of goods sold 20.2 Depreciation 13.9 EBIT $19.6 Interest expense 12.4 EBT $ 7.2 Taxes (25%) 1.8 Net Income $ 5.4 a. Compute TC1's degree of financial, operating, and combined leverage if one-half of the costs of good sold are variable costs and one-half are fixed costs. The only variable costs are one-half of COGS, or $10.1 DOL = (S – VC) / (S – VC – FC) = ($53.7 – 10.1) / ($53.7 – 20.2 – 13.9) = 2.22 DFL = EBIT / (EBIT – I) = $19.6 / ($19.6 – 12.4) = 2.72 DCL = DOL x DFL = 2.22 x 2.72 = 6.04 b. Assume during the current year TC1's sales rise to $59.5 million. What is your estimate of TC1's net income this year? The percentage change in sales is ($59.5 – 53.7)/$53.7 = 10.80% The DCL shows the effect of a change in sales on net income: 10.80% x 6.04 = 65.23% Net income is expected to rise 65.23% to $5.4 x (1 + .6523) = $8.92 c. Assume during the current year TC1’s sales fall to $49.3 million. What is your revised estimate for TC1’s net income? The percentage change in sales is ($49.3 – 53.7)/$53.7 = -8.19% The DCL shows the effect of a change in sales on net income: -8.19% x 6.04 = 49.47% Net income is expected to fall 49.47% to $5.4 x (1 - .4947) = $2.73 20. Company A1 intends to raise $3 million by either of two financing plans: Plan A: Sell 100,000 shares of stock at $30 net to firm Plan B: Issue $3 million in long term bonds with a 10 percent coupon The firm expects an EBIT of $1 million. Currently A1 has 50,000 shares outstanding and no debt in its capital structure. Its tax rate is 34 percent. a. What EBIT indifference level is associated with these two proposals? Earnings per share equals (EBIT – I – Tax)/number of shares [EBIT – 0 - .34(EBIT – 0)]/150,000 = [EBIT – 300,000 - .34(EBIT – 300,000)]/50,000 Simplifying: (.66 EBIT)/150 = (.66EBIT – 198,000)/50 Solving, EBIT = $450,000 eps equals $1.98 under both plans when EBIT equals $450,000 b. Draw an EBIT/eps graph showing the various levels of eps and EBIT to include the expected EBIT. What should A1 do in this case? Expected EBIT 50% lower EBIT 50% higher Plan A Plan B Plan A Plan B Plan A Plan B Debt $0 $3,000,000 $0 $3,000,000 $0 $3,000,000 Equity $4,500,000 $1,500,000 $4,500,000 $1,500,000 $4,500,000 $1,500,000 Common Stock Price 30 30 30 30 30 30 Initial shares 50,000 50,000 50,000 50,000 50,000 50,000 New issue 100,000 $0- 100,000 $0 100,000 $0 Total number of shares 150,000 50,000 150,000 50,000 150,000 50,000 EBIT $1,000,000 $1,000,000 $500,000 $500,000 $1,500,000 $1,500,000 Interest rate 10% 10% 10% 10% 10% 10% Interest expense 0 300,000 0 300,000 0 300,000 Tax Rate 34% 34% 34% 34% 34% 34% Tax $340,000 $238,000 $170,000 $68,000 $510,000 $408,000 Net Income $660,000 $462,000 $330,000 $132,000 $990,000 $792,000 Eps $4.40 $9.24 $2.20 $2.64 $6.60 $15.84 EBIT (thousand) 0 500 1,000 1,500 Plan A eps $0 $2.20 $4.40 $6.60 Plan B eps $(3.96) $2.64 $9.24 $15.84 If the firm is fairly sure of that EBIT levels will be around $1 million, plan B looks to be preferable. 21. Big 10+1 Corp. intends to raise $5 million by one of two financing plans: Plan A: Sell 1,250,000 shares at $4 per share net to the firm. Plan B: Issue $5 million in ten year debentures with a 9 percent coupon rate. The firm expects an EBIT level of $800,000. Currently Big 10 has 100,000 shares outstanding and $2 million of debt with a 5 percent coupon in its capital structure the tax rate is 34 percent. a. Draw an EBIT/eps graph showing the various levels of EPS and EBIT. Plan A Plan B Plan A Plan B Plan A Plan B EBIT 50% below expectation EBIT 50% above expectation Debt $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000 New Debt $5,000,000 $5,000,000 $5,000,000 Total Debt $2,000,000 $7,000,000 $2,000,000 $7,000,000 $2,000,000 $7,000,000 Equity Common Stock Price $4 $4 $4 Number of shares 100,000 100,000 100,000 100,000 100,000 100,000 Number of new shares 1,250,000 1,250,000 1,250,000 Total number of shares 1,350,000 100,000 1,350,000 100,000 1,350,000 100,000 EBIT $800,000 $800,000 $400,000 $400,000 $1,200,000 $1,200,000 Interest rate (old debt) 5% 5% 5% 5% 5% 5% Interest rate (new debt) 9% 9% 9% Interest expense on old debt 100,000 100,000 100,000 100,000 100,000 100,000 Interest expense on new debt 0 450,000 0 450,000 0 450,000 Total Interest Expense 100,000 550,000 100,000 550,000 100,000 550,000 Tax Rate 34% 34% 34% 34% 34% 34% Tax 238,000 85,000 102,000 -51,000 374,000 221,000 Net Income 462,000 165,000 198,000 -99,000 726,000 429,000 Eps 0.342 1.65 0.147 -0.99 0.538 4.29 EBIT 400 800 1,200 Plan A eps 0.147 0.342 0.538 Plan B eps -0.99 1.65 4.29 b. What is the EBIT indifference point? Earnings per share equals (EBIT – I – Tax)/number of shares [EBIT – 100,000 - .34(EBIT – 100,000)]/1,350,000 = [EBIT – 550,000 - .34(EBIT – 550,000)]/100,000 Simplifying, (.66 EBIT – 66,000)/1350 = (.66EBIT – 363,000)/100 Solving, EBIT = $586,000 eps equals $0.24 under both plans when EBIT equals $586,000 c. When will eps be zero under either alternatives? eps will be zero whenever EBIT = interest expense. Under this situation, EBT is zero, net income will be zero, and eps will be zero. Plan A: EBIT = $100,000 Plan B: EBIT = $550,000 d. What type of financing should the firm choose? Under plan B, EBIT can decline over 25 percent from its expected level of $800,000 and still result in a higher level of earnings per share. Equity financing (plan A) will create much more stable, but lackluster earnings over the range examined. If management believes EBIT will be in the $800,000 range, it should choose plan B. e. Suppose under the equity financing option at an EBIT level of $800,000, the firm's P/E ratio is 10; for the debt financing option, the P/E ratio is 7. What should the firm do? Plan A Plan B EBIT 800,000 800,000 P/E 10 7 eps 0.342 1.65 Market Price 3.422 11.55 If stock price is the only factor is considered, Plan B will be chosen 22. Champion Telecommunications is restructuring. Currently Champion has no debt outstanding. After it restructures, debt will be $5 million. The rate offered to bondholders is 10 percent. Champion currently has 700,000 shares outstanding at a market price of $40/share. Earnings per share are expected to rise. a. What is the minimum level of EBIT that Champion is expecting? Ignore the consequences of taxes. If Champion is restructuring that means the debt issue will be used to repurchase shares of stock. If $5 million in debt is being issued, 125,000 shares of stock can be repurchased at $40 per share. Under the restructuring, the firm will have 575,000 shares of stock and $5 million in debt at an interest rate of 10 percent. Under the current structure, the firm has 700,000 shares and no debt. The minimum level of EBIT the firm is expecting will be the indifference level between these two plans. Ignoring taxes, we have EBIT/700,000 = (EBIT - $500,000)/575,000 Solving for EBIT, the indifference level of EBIT is $2,800,000. b. Calculate the minimum level of EBIT that Champion Telecommunications' managers are expecting, if the interest rate on debt is 5 percent. If the interest rate is 5 percent, the interest expense will fall to 5 percent of $5 million or $250,000. Solving for the indifference point between the current structure and the financing structure at 5-percent interest, we have EBIT/700,000 = (EBIT - $250,000)/575,000 Solving for EBIT, the indifference level of EBIT is $1,400,000. c. Assume that Champion Telecommunications had EBIT of $2 million; was the leverage beneficial in part a? In part b? With a 10 percent interest rate, the leverage would not be beneficial. The indifference point of $2.8 million exceeds the EBIT level so the less-levered structure will have the higher earnings per share. With a 5 percent interest rate, leverage would be beneficial as the indifference point of $1.4 million would be far below the EBIT level of $2 million. Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288
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