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# Current level of EBIT to calculate the times interest earned (TIE) ratio for each capital structure

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ABC is a successful winery company with a stable market share of Chinese wine in China. The sales growth rate for its Chinese wine in the coming 5 years is expected to be stagnant because of the fierce competition in the winery market and demographic decline in the number of Chinese liquor drinkers. The CEO of the company, Mr Chris Wong, is under pressure to lead the company to earn higher profits and to maximize shareholders' wealth.

In this regards, Paul Cheung, the financial analyst of the firm, was assigned by the CEO to evaluate the firm's capital structure by using scenario analysis. Currently the company contains 10% debt and 90% equity. This makes Paul realize that the company may be under-utilizing its financial leverage.

To evaluate the firm's capital structure, Paul has gathered the data summarized in the following table. He has listed out information based on the current 10% debt ratio, together with 2 alternative capital structure scenarios: Scenario 1 is 30% debt and Scenario 2 is 60% debt. The 2 scenarios are the choices which the CEO would like to consider.

Capital Structure Structure analysis

(I) Current (10% debt)
Common stock outstanding: 150000 shares
Equity required return:10%
Long term debt: \$1500000
Coupon rate: 5%

(II) Scenario 1 (30% debt)
Common stock outstanding: 100500 shares
Equity required return:12%
Long term debt: \$4500000
Coupon rate: 6%

(III) Scenario (60% debt)
Common stock outstanding: 40000 shares
Equity required return:16%
Long term debt: \$9000000
Coupon rate: 10%

The percentage of Long Term debts in each of the 2 scenarios is based on the firm's current level of \$15million total financing. The money raised by debts under both scenarios is used for repurchase of shares. The number of common stock outstanding in each scenario is determined by the CEO and presented in the table. It is expected that the firm's earnings before interest and taxes (EBIT) will be stable at its current level of \$1.4million in the foreseeable future. The company is subject to the 40% tax rate.

(a) Use the current level of EBIT to calculate the times interest earned (TIE) ratio for each capital structure. Evaluate the 3 capital structure scenarios using the times interest is earned and debt ratio. (25marks)

(b) Use EPS equal to zero, and EBIT equal to \$1,400,000 and \$900,000 to draw an EBIT-EPS graph. In your graph, please include the current and the 2 proposed capital structures. Show your EPS calculation clearly. (23marks)

(c) According to your findings in part (b), which capital structure will maximize ABC's earning per shares (EPS) with its EBIT of \$1,400,000? Why might this not be the best capital structure? (15marks)

(d) Assume all after-tax earnings will be distributed to shareholders as dividends. Using the zero growth rate valuation model (g=0), find out the share price of ABC under of the three capital structures. (20marks)

(e) On the basis of your findings in part (c) and (d), which capital structure would Paul recommend to the CEO? Why? (17marks)

#### Solution Preview

The percentage of Long Term debts in each of the 2 scenarios is based on the firm's current level of \$15million total financing. The money raised by debts under both scenarios is used for repurchase of shares. The number of common stock outstanding in each scenario is determined by the CEO and presented in the table. It is ...

#### Solution Summary

Solution helps in estimating the current level of EBIT to calculate the times interest earned (TIE) ratio for each capital structure

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## Five questions: HD & LD, Muscarella Inc., Quigley Inc.

1. Which of the following statements is CORRECT?

a. The ratio of long-term debt to total capital is more likely to experience seasonal
fluctuations than is either the DSO or the inventory turnover ratio.
b. If two firms have the same ROA, the firm with the most debt can be expected to have the
lower ROE.
c. An increase in the DSO, other things held constant, could be expected to increase the
total assets turnover ratio.
d. An increase in the DSO, other things held constant, could be expected to increase the
ROE.
e. An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be
expected to lower the profit margin.

2. Companies HD and LD have the same tax rate, sales, total assets, and basic earning power.
Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore,

a higher interest expense. Which of the following statements is CORRECT?
a. Company HD has a lower equity multiplier.
b. Company HD has more net income.
c. Company HD pays more in taxes.
d. Company HD has a lower ROE.
e. Company HD has a lower times interest earned (TIE) ratio.

3. Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and
they pay the same interest rate on their debt. However, company HD has a higher debt ratio.
Which of the following statements is CORRECT?

a. Given this information, LD must have the higher ROE.
b. Company LD has a higher basic earning power ratio (BEP).
c. Company HD has a higher basic earning power ratio (BEP).
d. If the interest rate the companies pay on their debt is more than their basic earning power
(BEP), then Company HD will have the higher ROE.
e. If the interest rate the companies pay on their debt is less than their basic earning power
(BEP), then Company HD will have the higher ROE.

4. Muscarella Inc. has the following balance sheet and income statement data:

Cash \$ 14,000 Accounts payable \$ 42,000
Receivables 70,000 Other current liabilities 28,000
Inventories 210,000 Total CL \$ 70,000
Total CA \$294,000 Long-term debt 70,000
Net fixed assets 126,000 Common equity 280,000
Total assets \$420,000 Total liab. and equity \$420,000
Sales \$280,000
Net income \$ 21,000

The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the
current ratio to equal the industry average, 2.70, without affecting either sales or net income.
Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change?
a. 4.28%
b. 4.50%
c. 4.73%
d. 4.96%
e. 5.21%

5. Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be \$301,770, operating costs to be \$266,545, assets to be \$200,000, and its tax rate to be 35%.
Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt
would be 8.8%, but the TIE ratio would have to be kept at 4.00 or more. Under Plan B the
maximum debt that met the TIE constraint would be employed. Assuming that sales, operating
costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure?

a. 3.83%
b. 4.02%
c. 4.22%
d. 4.43%
e. 4.65%

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