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    Capital Structure Performance Analysis

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    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)
    $1,000,000
    10%
    -
    -
    $ 100,000
    $500,000
    13%
    $500,000
    7%
    $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:
    Proportion
    of Debt
    After-tax Cost of
    Debt, ki
    Cost of
    Equity, ke
    0.00
    0.10
    0.20
    0.30
    0.40
    0.50
    0.60
    -
    4.7%
    4.9
    5.1
    5.5
    6.1
    7.5
    12.0%
    12.1
    12.5
    13.0
    13.9
    15.0
    17.0
    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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