Capital structure
4. Degree of Operating Leverage The Island Paper Company has
fixed operating costs of $380,000, variable operating costs per unit of
$16, a selling price of $63.50 per unit.
a. Calculate the operating breakeven point in units and sales dollars.
b. Calculate the firm’s EBIT at 9,000, 10,000, and 11,000 units,
respectively.
c. Using 10,000 units as a base, what are the percentage changes in
units sold and EBIT as sales move from the base to the other sales
levels used in b.
d. Use the percentages computed in c to determine the degree of
operating leverage (DOL).
Use the degree of operating leverage formula to determine the DOL at
10,000 units.
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Capital structure
Answer:
QBE=8,000 units
EBIT
9,000
47,500
Q
10,000
95,000
%CHANGE
-50%
BASE
11,000
142,500
50%
DOL=5
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Capital structure
7.Degree of Financial Leverage The Spring Water Company has
EBIT of $67,500. Interest costs are $22,500 and the firm has
$15,000 shares of common stock outstanding. Assume a 40
percent tax rate.
a. Use the degree of financial leverage (DFL) formula to calculate
the DFL for the firm.
b. Assuming the firm also has 1,000 shares of preferred stock
paying a $6.00 annual dividend per share, what is the DFL.
Answer:
a. DFL=1.5
DFL=1.93
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Capital structure
10.Their fixed operating costs are $20,000, variable operating costs
are $18 per unit, and the motors sell for $23 each. Johnson has
$60,000 in 10 percent bonds and 20,000 shares of common stock
outstanding. The firm is in the 40 percent tax bracket.
a. What is Johnson’s operating breakeven point in units?
b. What is Johnson’s financial breakeven point?
c.
What is Johnson’s total breakeven point?
Answer:
Q=4,000 units
EBIT=$6,000
Q=5,200 units
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Capital structure
12.Optimal capital structure and Hamada equation Aaron
Athletics is trying to determine its optimal capital structure. The
company’s capital structure consists of debt and common stock. In
order to estimate the cost of debt, the company has produced the
following table:
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Capital structure
The company’s tax rate, T, is 40 percent.
The company uses the CAPM to estimate its cost of common
equity, ks. The risk-free rate is 5 percent and the market risk
premium is 6 percent. Aaron estimates that if it had no debt its
beta would be 1.0. (Its “unlevered beta,” bU, equals 1.0.)
On the basis of this information, what is the company’s optimal
capital structure, and what is the firm’s cost of capital at this
optimal capital structure?
Answer: the optimal capital structure is 40% debt and 60% equity.
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Capital structure
41. Capital structure and stock price The following information applies to Lott
Enterprises:
Operating income (EBIT) $300,000
Debt
$100,000
Interest expense
$ 10,000
Tax rate
40%
Shares outstanding 120,000
EPS
$1.45
Stock price
$17.40
The company is considering a recapitalization where it would issue
$348,000 worth of new debt and use the proceeds to buy back $348,000 worth of
common stock. The buyback will be undertaken at the pre-recapitalization share
price ($17.40). The recapitalization is not expected to have an effect on operating
income or the tax rate. After the recapitalization, the company’s interest expense
will be $50,000.
Assume that the recapitalization has no effect on the company’s price earnings (P/E)
ratio. What is the expected price of the company’s stock following the
recapitalization?
Answer: Price =$18.00.
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Capital structure
43. Hamada equation and cost of equity Simon Software Co.
is trying to estimate its optimal capital structure. Right now,
Simon has a capital structure that consists of 20 percent debt
and 80 percent equity. (Its D/E ratio is 0.25.) The risk-free rate
is 6 percent and the market risk premium, kM – kRF, is 5 percent.
Currently the company’s cost of equity, which is based on the
CAPM, is 12 percent and its tax rate is 40 percent. What would
be Simon’s estimated cost of equity if it were to change its
capital structure to 50 percent debt and 50 percent equity?
Answer: ks = 14.35%.
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