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Analyzing Firm’s Capital Structure

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Assume that a company has $10 million in assets (where the market value of the assets is equal to the book value of the assets) and no debt. The company's marginal tax rate is 35% and has 500,000 shares outstanding. The company's earnings before interest and taxes (EBIT) is $3.88 million. The firm's stock price is $27 per share and the cost of equity is 11%.

The company is thinking of issuing bonds and simultaneously repurchasing a portion of its stock. If the company changes its capital structure from no debt to 25% debt based on market values, the firm's cost of equity will increase to 13% because of the increased risk. The bonds can be sold at a cost of 9%. The firm's earnings are not expected to grow over time. All of its earnings will be paid out as dividends.

Answer the following questions:
a.What impact will this utilization of this debt have on the value of the company?
b.What's going to be the company's EPS after the recapitalization?
c.What's going to be the company's new stock price?
d.The $3.88 million EBIT discussed above is determined from this probability distribution:

Probability EBIT ($)
0.05 - 1 million
0.25 2.3 million
0.4 4 million
0.25 5.8 million
0.05 6.1 million

What's the times interest earned ratio at each probability level?

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Solution Summary

Analyzing a Firm's Capital Structure

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Capital Structure Performance Analysis

3. Two firms, No Leverage, Inc., and High Leverage, Inc., have equal levels of operating risk
and differ only in their capital structure. No Leverage is unlevered and High Leverage has
$500,000 of perpetual debt in its capital structure. Assume that the perpetual annual income
of both firms available for stockholders is paid out as dividends. Hence, the growth
rate for both firms is zero. The income tax rate for both firms is 40 percent. Assume that
there are no financial distress costs or agency costs. Given the following data:
No Leverage, Inc. High Leverage, Inc.
Equity in capital structure
Cost of equity, ke
Debt in capital structure
Pretax cost of debt, kd
Net operating income (EBIT)
$ 100,000
determine the
Market value of No Leverage, Inc.
b. Market value of High Leverage, Inc.
c. Present value of the tax shield to High Leverage, Inc.

4. Jersey Computer Company has estimated the costs of debt and equity capital (with bankruptcy
and agency costs) for various proportions of debt in its capital structure:
of Debt
After-tax Cost of
Debt, ki
Cost of
Equity, ke
a. Determine the firm's optimal capital structure, assuming a marginal income tax rate
(T) of 40 percent.
b. Suppose that the firm's current capital structure consists of 30 percent debt (and
70 percent equity). How much higher is its weighted cost of capital than at the optimal
capital structure?

2. The Alexander Company reported the following income statement for 2006:
Sales $15,000,000
Less Operating expenses
Wages, salaries, benefits $ 6,000,000
Raw materials 3,000,000
Depreciation 1,500,000
General, administrative, and selling expenses 1,500,000
Total operating expenses 12,000,000
Earnings before interest and taxes (EBIT) $ 3,000,000
Less Interest expense 750,000
Earnings before taxes $ 2,250,000
Less Income taxes 1,000,000
Earnings after taxes $ 1,250,000
Less Preferred dividends 250,000
Earnings available to common stockholders $ 1,000,000
Earnings per share-250,000 shares outstanding $ 4.00
Assume that all depreciation and 75 percent of the firm's general, administrative, and selling
expenses are fixed costs and that the remainder of the firm's operating expenses are
variable costs.

a. Determine Alexander's fixed costs, variable costs, and variable cost ratio.

b. Based on its 2006 sales, calculate the following:
The firm's DOL
The firm's DFL
The firm's DCL

c. Assuming that next year's sales increase by 15 percent, fixed operating and financial
costs remain constant, and the variable cost ratio and tax rate also remain constant,
use the leverage figures just calculated to forecast next year's EPS.

d. Show the validity of this forecast by constructing Alexander's income statement for
next year according to the revised format.

e. Construct an EPS-EBIT graph based on Alexander's 2006 income statement.

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