Firm U Firm L Total capital $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $10,000 $20,000 $10,000 Equity $20,000 $10,000 Probability 0.25 0.50 0.25 0.25 0.50 0.25 $ 6,00 4,000 $ 9,000 6,000 $ 6,00 _ 4,000 $ 9,00 _ 6,000 Sales $12,000 $12,000 Operating costs Earnings before 8,000 8,000 interest and taxes $ 2,000 $ 3,000 $ 4,000 $ 2,000 $ 3,000 $ 4,000 1,200 $ 2,800 Interest (12%) $ 2,000 1,200 $ 800 $ 3,000 $ 4,000 Earnings before taxes Тахes (40%) 800 1,200 1,600 320 $ 1.200 $ 1,800 1,120 $ 1,680 Net income $ 2.400 480 ROIC 6.0% 9.0% 12.0% ROE 6.0% 9.0% 12.0% 4.8% 16.8% TIE 1.7x 3.3x Expected ROIC Expected ROE Expected TIE 9.0% 9.0% 10.8% 2.5x 2.1% GROE 2.1% 4.2% OTE 0.6x FIGURE IE
OPTIMAL CAPITAL STRUCTURE
Assume that you have just been hired as business manager of Campus Deli(CD) , Which os located adjeacent to the campus. Sales were $1,100,000 last year variable costs were 60% of sales and fixed costs were $40,000. Therefore, EBIT totaled $400,000.
Because the university's enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is $2 million, and 80,000 shares are outstanding. The management group owns about 50% if the stock, which is traded in the over-the counter market.
CD currently has no debt-it is an all-equity firm- and its 80,000 shares outstanding sell at a price of $25 per share, which is also the book value. The firms federal-plus-state tax rate is 40% on the basis of statement made in your finance text, you belive that CD's shareholders would be better off if some debt financing were used. When you suggested this to your new boss, She encouraged you to pursue the idea but to provide support for the suggestion.
In today's market, the risk-free rate, rRF is 6% itthe market risk perimium, RPM, is 6% CD's unlevered beta, bU, is 10. CD currently has no debt, so its
a. 1. What is business risk? What factors influence a firms business risk?
2. What is operating leverage, and how does it affect a firm's business risk?
3. What is the firm's
b.1What do the terms financial leverage and financial risk mean?
2 How does financial risk differ from business risk?
c. To develop an example that can be presented to CD's management as an illustration, consider two hypothetical firms: Firm U with zero debt financing and Firm L with $, of 12% debt. Both firms have $20,000 in invested capital and a 40% federal-plus-state tax rate, and they have the following EBIT probability distribution for next year:
| Probability | |
| 025 | $2000 |
| 0.50 | 3000 |
| 025 | 4000 |
1. Complete the partial income statements and the firm's ratios in Table IC 14.1
2. Be prepared to discuss each entry in the table and to explain how this example illustrates the expected
d. After speaking with local investment banker you obtain the following estimates of the cost of debt at different debt levels(in thousands of dollars)
|
Amount Borrowed |
Debt/capital Ratio |
D/E Ratio |
Bond Rating |
r<j |
| $0 | 0 | 0 | - | - |
| 250 | 0.125 | 0.1429 | AA |
8.0% |
| 500 | 0.250 | 0333 | A | 9.0 |
| 750 | 0375 | 0.6000 | BBB | 113 |
| 1,000 | 0.500 | 1.0000 | BB | 14.0 |
Now consider the optimal capital structure for CD
1. To begin, define the terms optimal capotal structure and target capital structure.
2. Why does CD's bond rating and cost of debt depend on the amount of money borrowed?
3. Assume that shares could be repurchased at the current market price of $25 per share. Calculate CD's expected EPS and TIE at debt levels of $0,$250,000, $500000, $750,000 and $1,000,000
How many shares would remain after recapitalization under each scenario?
4. Using the Hamada equation, What is the cost of equity if CD recapitalizes with $250,000 of debt? $500,000? $750,000? $1000,000?
5. Considering only on the levels of debt discusssed, What is the capital structure that minimizes CD's WACC?
6. What would be the new stock price if CD recapitalizes with $250,000 of debt? $500,000? $750,000? $ 1000,000? Recall that the payout ratio is 100%, so g 0.
7 Is EPS maximized at the debt level that maximises share price? why or why not ?
8. Considering only the levels of debt discussed, What is CD's optimal capital structure?
9. What is the WACC at the optimal capital structure?
d. Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk than originally estimated?
e. What are some factors a manager should consider when establishing his or her firm's target capital structure?
f. Put lables on Figure IC 14. 1 and then discuss the graph as you might use it to explain to your boss why CD might want to use some debt.
8. How does the existence of asymmetric information and signaling affect capital structure ?
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