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Lecture

SOC 202 Lecture Notes - Capital Structure, Ordinary Income, Tax Shield


Department
Sociology
Course Code
SOC 202
Professor
Louis Pike

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CHAPTER16
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
POLICY
Learning Objectives
LO1 The effect of financial leverage on firm value and cost of capital.
LO2 The impact of taxes and bankruptcy on capital structure choice.
LO3 The essentials of the bankruptcy process.
Answers to Concepts Review and Critical Thinking Questions
1. (LO1) Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly
related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely to the
firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial
risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater
leverage.
2. (LO1) No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to
remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt,
the WACC does not necessarily rise.
3. (LO1) Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot
easily be identified or quantified, it’s practically impossible to determine the precise debt/equity ratio that
maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes much more
expensive, it’s probably true that the firm is too highly leveraged.
4. (LO1) The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use
greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs,
tend to use less financial leverage. Such industries also have a higher concentration of growth and startup
firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more
predictable future earnings to use more debt financing. These are typically the firms with the greatest need for
external financing and the greatest likelihood of benefiting from the interest tax shelter.
5. (LO1) It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses.
6. (LO1) Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate
level.
7. (LO3) One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in
shareholders’ best interest by managing this asset in ways that maximize its value. To the extent that a
bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable use of the
process.
8. (LO3) As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be
the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the
interest charged incorporates it.
9. (LO1, 2) The basic goal is to minimize the value of non-marketed claims.
10. (LO3) The two most basic options are liquidation or reorganization, though creative alternatives may exist.
11. (LO3) g, f, d, b, c, a, e.
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Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to
space and readability constraints, when these intermediate steps are included in this solutions manual, rounding
may appear to have occurred. However, the final answer for each problem is found without rounding during any
step in the problem.
Basic
1. (LO1)
a. A table outlining the income statement for the three possible states of the economy is shown below. The
EPS is the net income divided by the 5,000 shares outstanding. The last row shows the percentage
change in EPS the company will experience in a recession or an expansion economy.
Recession Normal Expansion
EBIT $14,000 $28,000 $36,400
Interest 0 0 0
NI $14,000 $28,000 $36,400
EPS $ 2.80 $ 5.60 $ 7.28
%EPS –50 ––– +30
b. If the company undergoes the proposed recapitalization, it will repurchase:
Share price = Equity / Shares outstanding
Share price = $250,000/5,000
Share price = $50
Shares repurchased = Debt issued / Share price
Shares repurchased =$90,000/$50
Shares repurchased = 1,800
The interest payment each year under all three scenarios will be:
Interest payment = $90,000(.07) = $6,300
The last row shows the percentage change in EPS the company will experience in a recession or an
expansion economy under the proposed recapitalization.
Recession Normal Expansion
EBIT $14,000 $28,000 $36,400
Interest 6,300 6,300 6,300
NI $7,700 $21,700 $30,100
EPS $2.41 $ 6.78 $9.41
%EPS –64.52 ––– +38.71
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2. (LO2)
a. A table outlining the income statement with taxes for the three possible states of the economy is shown
below. The share price is still $50, and there are still 5,000 shares outstanding. The last row shows the
percentage change in EPS the company will experience in a recession or an expansion economy.
Recession Normal Expansion
EBIT $14,000 $28,000 $36,400
Interest 0 0 0
Taxes 4,900 9,800 12,740
NI $9,100 $18,200 $23,660
EPS $1.82 $3.64 $4.73
%EPS –50 ––– +30
b. A table outlining the income statement with taxes for the three possible states of the economy and
assuming the company undertakes the proposed capitalization is shown below. The interest payment and
shares repurchased are the same as in part b of Problem 1.
Recession Normal Expansion
EBIT $14,000 $28,000 $36,400
Interest 6,300 6,300 6,300
Taxes 2,695 7,595 10,535
NI $5,005 $14,105 $19,565
EPS $1.56 $4.41 $6.11
%EPS –64.52 ––– +38.71
Notice that the percentage change in EPS is the same both with and without taxes.
3. (LO1, 2)
a. Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market
value of equity. Using the equation for ROE:
ROE = NI/$250,000
The ROE for each state of the economy under the current capital structure and no taxes is:
Recession Normal Expansion
ROE .0560 .1120 .1456
%ROE –50 ––– +30
The second row shows the percentage change in ROE from the normal economy.
b. If the company undertakes the proposed recapitalization, the new equity value will be:
Equity = $250,000 – 90,000
Equity = $160,000
So, the ROE for each state of the economy is:
ROE = NI/$160,000
Recession Normal Expansion
ROE .0481 .1356 .1881
%ROE –64.52 ––– +38.71
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