Bus-fpx4070 Assessment 8 attempt 1

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Jan 9, 2024

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Capital Structure and Financial Health 1 Capital Structure and Financial Health Adiyah Williams Capella University Problem 1: Optimal Capital Structure

Capital Structure and Financial Health 2 XYZ Inc. is setting its target capital structure. The CFO of XYZ Inc. believes that the optimal debt-to-capital ratio is between 25 percent and 60 percent. Her staff derived following the projections. Various debt levels were considered. Dept/Capital Ratio Projected EPS Projected Stock Price 25% $4.20 $40.00 35% $4.45 $41.50 45% $4.75 $41.25 60% $4.50 $40.59 Assuming that the firm uses only debt and common equity, what is XYZ's optimal capital structure? At what debt-to-capital ratio is the company's WACC minimized? "The amount of debt and equity employed by a firm to fund its operations and finance its asset" is how CFI defines capital structure—the debt-to-capital or debt-to-equity ratio. "The proportion of debt and equity that results in the lowest weighted average cost of capital (WACC) for the firm is often defined as the optimal capital structure of a firm," they continue. A lower cost of capital in the capital structure translates into less debt for the business. XYZ's ideal capital structure would be 45%, with the expected stock price at the higher end of the spectrum. WACC for XYZ would be lowest at a debt-to-capital ratio of 45%. The company's debt is reduced because the predicted EPS is at the higher end of the chart when the cost of capital is in the center. Problem 2: Break-Even Analysis

Capital Structure and Financial Health 3 XYZ Inc. sells photoframes for $20 each. The fixed costs are $60,000, and the variable costs are $7 per photo frame. 1. What is the firm's gain or loss at sales of 6,000 photo frames? At 15,000 photoframes? =$20 - $7 =$20 - $7 =$13 per unit =$13 per units 6,000 X $13 = 78,000 15,000 X $13 = 195,000 Fixed cost @ $60,000 Fixed cost $60,000 $78,000-60,000=$18,000 $195,000-60,000=135,000 Or 6,000 x 20= 120,000 15,000 x 20 =300,000 6,000 x 7=- 42,000 15,000 x 7 = 105,000 Fixed Cost = -60,000 Fixed Cost= -60,000 Gain=$18,000 Gain= $135,000 2. How would the break-even point be affected if the selling price was raised to $25? How is this analysis significant? The break-even point is the lowest number of sales required to pay production costs for a business. Since fixed costs are standard operating procedures, they are not subject to variation based on unit sales. If units were sold for $13 each, 4,615 more units would need to be sold to break even. Break-even point = Fixed cost / (price – variable cost)

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Capital Structure and Financial Health 4 = $60,000 / ($25 – $7) = $60,000 / $18 = 3,333.33 units = break-even point $60,000 / ($20 – $7) $60,000 / $13 = 4,615 units = break-even point 3. If the selling price was raised to $25 but variable costs rose to $13 a week, what would happen to the break-even point? Raising the price in line with the rise in variable costs would be more profitable. $60,000 / ($25 – $13) $60,000 / $12 = 5,000 units = break-even point Problem 3: WACC and Optimal Capital Structure This problem is easiest to complete in Excel. The structure consists of only debt and common equity. XYZ's finance department staff created the following table showing the firm's debt cost at different debt levels: Debt-to-Capital Ratio Equity-to- Capital Ratio Debt-to-Equity Ratio Bond Rating Before-Tax Cost of Debt 0.0 1.0 0.00 A 6.0%

Capital Structure and Financial Health 5 0.2 0.8 0.25 BBB 7.0% 0.4 0.6 0.67 BB 9.0% 0.6 0.4 1.50 C 11.0% 0.8 0.2 4.00 D 14.0% XYZ uses the CAPM to estimate its cost of common equity and estimates that the risk-free rate is 4 percent, the market risk premium is 7 percent, and its tax rate is 35 percent. XYZ estimates that if it had no debt, its "unlevered" beta would be 1.5. 1. What would be its WACC at the optimal capital structure? What would the firm's optimal capital structure be? SEE ATTACHED EXCEL DOC 2. If XYZ's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure? Managers should take working capital-related action out of anticipation. They will have to reduce their debt and accumulate more assets. XYZ will have to take action to reduce operating capital until the risk has subsided or the business can more easily absorb it. 3. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ's target capital structure? The corporate tax rate increase will impact XYZ's target capital structure. Due to tax deductions, the company's debt would decrease. Because of the impact on the debt-to-capital ratio, this would also lower WACC.

Capital Structure and Financial Health 6 Problem 4: Cost of Trade Credit and Bank Loan XYZ Inc. buys $10 million of materials (net of discounts) on terms of 3/5, net 60, and it currently pays on the 5th day and takes discounts. XYZ plans to expand, which will mean additional financing. 1. If XYZ decides to forgo discounts, could it obtain much additional credit? = 10,000,000 / [365 / (60-5)] = 10,000,000 / (365 /55) = 10,000,000 / 6.636 = 1,506,849.32 2. What would be the nominal and effective cost of that credit? Nominal = 3% / [(1.00 - .03) x 365 / (60 – 5)] = (.03 / .97) x (365 / 55)] = (3.10%) x (6.636) = 20.57% Effective cost = [1+.031)^6.636 -1+20.57 = 1.031^6.636-1+20.57 =2.655-1+20.57 =1.655 + 20.57

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Capital Structure and Financial Health 7 =22.23% 3. What would be the effective cost of the bank loan if the company could get the funds from a bank at a rate of 8 percent and if the interest was paid monthly? All of this should be based on a 365-day year. Rate per day = nominal rate / 365 days = .2057 / 365 = .00056356164 Rate per day x the amount of the loan x days in the month = .00056356164 x 10,000,000 x (365/12) = .00056356164 x 10,000,000 x 30.42 = 5,635.62 x 30.42 = $171,435.45m = (1 + .2057/12)12 – 1 = 7.8% 4. Should XYZ use bank debt or additional trade credit? Explain. With the bank loan at 7.8% and the nominal and effective rates at 22.22% and 25.57%, respectively, the bank loan would be the most economical choice for XYZ.