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Calculating the Optimum level of capital required.

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McGraw Industries, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm's management has been instructed by its board to institute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value.
In this regard, the firm's chief financial officer (CFO), Ron Lewis, has been charged with evaluating the firm's capital structure. Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate
financial leverage. To evaluate the firm's capital structure, Lewis has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures?A (30% debt ratio)
and B (50% debt ratio)?that he would like to consider.

Lewis expects the firm's earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.

TO DO
1. Use the current level of EBIT to calculate the times interest earned ratio for
each capital structure. Evaluate the current and two alternative capital structures
using the times interest earned and debt ratios.
2. On the basis of your findings in parts c and d, which capital structure would
you recommend? Why?

and B (50% debt ratio)?that he would like to consider.
Lewis expects the firm's earnings before interest and taxes (EBIT) to remain
at its current level of $1,200,000. The firm has a 40% tax rate.

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Solution Summary

The problem deals with calculating the times interest earned for different levels of capital structuring.

The main problem deals with identifying the optimum point which maximizes company value.

Solution provided by:
Chidi Ngene, M. Sc.
Education
  • B. Sc., University of Nigeria
  • M. Sc., London South Bank University
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