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Ryerson University

Sociology

SOC 202

Louis Pike

Fall

Description

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.
S16-1 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
%ΔEPS –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
%ΔEPS –64.52 ––– +38.71
S16-2 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
%ΔEPS –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
%ΔEPS –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
%ΔROE –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
–64.52 ––– +38.71
%ΔROE
S16-3 c. If there are corporate taxes and the company maintains its current capital structure, the ROE is:
ROE .0364 .0728 .0946
%ΔROE –50 ––– +30
If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each
state of the economy is:
ROE .0313 .0882 .1223
%ΔROE –64.52 ––– +38.71
Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage
change in ROE is also the same with or without taxes.
4. (LO1)
a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS
under this capitalization will be:
EPS = $350,000/160,000 shares
EPS = $2.19
Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment
is the amount of debt times the interest rate, so:
NI = $350,000 – .08($2,800,000)
NI = $126,000
And the EPS will be:
EPS = $126,000/80,000 shares
EPS = $1.58
Plan I has the higher EPS when EBIT is $350,000.
b. Under Plan I, the net income is $500,000 and the EPS is:
EPS = $500,000/160,000 shares
EPS = $3.13
Under Plan II, the net income is:
NI = $500,000 – .08($2,800,000)
NI = $276,000
And the EPS is:
EPS = $276,000/80,000 shares
EPS = $3.45
Plan II has the higher EPS when EBIT is $500,000.
c. To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS
equal to each other and solve for EBIT. The breakeven EBIT is:
S16-4 EBIT/160,000 = [EBIT – .08($2,800,000)]/80,000
EBIT = $448,000
5. (LO1) We can find the price per share by dividing the amount of debt used to repurchase shares by the number
of shares repurchased. Doing so, we find the share price is:
Share price = $2,800,000/(160,000 – 80,000)
Share price = $35.00 per share
The value of the company under the all-equity plan is:
V = $35.00(160,000 shares) = $5,600,000
And the value of the company under the levered plan is:
V = $35.00(80,000 shares) + $2,800,000 debt = $5,600,000
6. (LO1, 2)
a. The income statement for each capitalization plan is:
I II All-equity
EBIT $39,000 $39,000 $39,000
Interest 16,000 24,000 0
NI $23,000 $15,000 $39,000
EPS $ 3.29 $ 3.00 $ 3.55
The all-equity plan; Plan II has the lowest EPS.
b. The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is
calculated as:
EPS = (EBIT – R DD/Shares outstanding
This equation calculates the interest payment (D D) and subtracts it from the EBIT, which results in the
net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the
interest term is zero. To find the breakeven EBIT for two different capital structures, we simply set the
equations equal to each other and solve for EBIT. The breakeven EBIT between the all-equity capital
structure and Plan I is:
EBIT/11,000 = [EBIT – .10($160,000)]/7,000
EBIT = $44,000
And the breakeven EBIT between the all-equity capital structure and Plan II is:
EBIT/11,000 = [EBIT – .10($240,000)]/5,000
EBIT = $44,000
The break-even levels of EBIT are the same because of M&M Proposition I.
c. Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT, we get:
[EBIT – .10($160,000)]/7,000 = [EBIT – .10($240,000)]/5,000
EBIT = $44,000
This break-even level of EBIT is the same as in part b again because of M&M Proposition I.
S16-5 d. The income statement for each capitalization plan with corporate income taxes is:
II All-equity
I
EBIT $39,000 $39,000 $39,000
Interest 16,000 24,000 0
Taxes 9,200 6,000 15,600
NI $ 13,800 $ 9,000 $ 23,400
EPS $ 1.97 $ 1.80 $ 2.13
The all-equity plan still has the highest EPS; Plan II still has the lowest EPS.
We can calculate the EPS as:
EPS = [(EBIT – R D)(1 – t C]/Shares outstanding
This is similar to the equation we used before, except now we need to account for taxes. Again, the
interest expense term is zero in the all-equity capital structure. So, the breakeven EBIT between the all-
equity plan and Plan I is:
EBIT(1 – .40)/11,000 = [EBIT – .10($160,000)](1 – .40)/7,000
EBIT = $44,000
The breakeven EBIT between the all-equity plan and Plan II is:
EBIT(1 – .40)/11,000 = [EBIT – .10($240,000)](1 – .40)/5,000
EBIT = $44,000
And the breakeven between Plan I and Plan II is:
[EBIT – .10($160,000)](1 – .40)/7,000 = [EBIT – .10($240,000)](1 – .40)/5,000
EBIT = $44,000
The break-even levels of EBIT do not change because the addition of taxes reduces the income of all
three plans by the same percentage; therefore, they do not change relative to one another.
7. (LO1) To find the value per share of the stock under each capitalization plan, we can calculate the price as the
value of shares repurchased divided by the number of shares repurchased. So, under Plan I, the value per share
is:
P = $160,000/(11,000 – 7,000 shares)
P = $40 per share
And under Plan II, the value per share is:
P = $240,000/(11,000 – 5,000 shares)
P = $40 per share
This shows that when there are no corporate taxes, the stockholder does not care about the capital structure
decision of the firm. This is M&M Proposition I without taxes.
S16-6 8. (LO1)
a. The earnings per share are:
EPS = $32,000/8,000 shares
EPS = $4.00
So, the cash flow from the company is:
Cash flow = $4.00(100 shares)
Cash flow = $400
b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the
proposed capital structure. The market value of the firm is:
V = $55(8,000)
V = $440,000
Under the proposed capital structure, the firm will raise new debt in the amount of:
D = 0.35($440,000)
D = $154,000
in debt. This means the number of shares repurchased will be:
Shares repurchased = $154,000/$55
Shares repurchased = 2,800
Under the new capital structure, the company will have to make an interest payment on the new debt.
The net income with the interest payment will be:
NI = $32,000 – .08($154,000)
NI = $19,680
This means the EPS under the new capital structure will be:
EPS = $19,680/(8,000 – 2,800) shares
EPS = $3.7846
Since all earnings are paid as dividends, the shareholder will receive:
Shareholder cash flow = $3.7846(100 shares)
Shareholder cash flow = $378.46
c. To replicate the proposed capital structure, the shareholder should sell 35 percent of their shares, or 35
shares, and lend the proceeds at 8 percent. The shareholder will have an interest cash flow of:
Interest cash flow = 35($55)(.08)
Interest cash flow = $154
The shareholder will receive dividend payments on the remaining 65 shares, so the dividends received
will be:

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