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Important Information about Leverage and Capital Structure

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P12-2 Breakeven comparisons-Algebraic. Given the price and cost data shown in the accompanying table for each of the three firms, F, G, and H, answer the following questions.

Firm F G H
Sale price per unit $18 $21 $30
Variable operating cost per unit 6.75 13.50 12.00
Fixed operating cost 45,000 30,000 90,000

a. What is the operating breakeven point in units for each firm?
b. How would you rank these firms in terms of their risk?

P12-21 Integrative-Optimal capital structure Medallion Cooling Systems, Inc., has total assets of $10,000,000, EBIT of $2,000,000, and preferred dividends of
$200,000 and is taxed at a rate of 40%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:

Capital Structure debt ratio Cost of debt, kd No. of common stock shares Required return, ks
0% 0% 200,000 12%
15% 8% 170,000 13%
30% 9% 140,000 14%
45% 12% 110,000 16%
60% 15% 80,000 20%

a. Calculate earnings per share for each level of indebtedness.
b. Use Equation 12.12 and the earnings per share calculated in part a to calculate a price per share for each level of indebtedness.
c. Choose the optimal capital structure. Justify your choice.

Solution Preview

For the first question...

The breakeven point is calculated as Fixed cost/(unit contribution margin)
Unit contribution margin = sales price per unit - variable cost per unit
We can calculate the breakeven point for the three firms
Firm F = 45,000/(18-6.75) = 4,000 units
Firm G = 30,000/(21-13.5) = 4,000 units
Firm H = 90,000/(30-12) = 5,000 units

A firm with higher breakeven point will ...

Solution Summary

The solution explains two problems relating to leverage and capital structure