Capital Structure Management in Practice: Answers To Questions
Capital Structure Management in Practice: Answers To Questions
CHAPTER 13
CAPITAL STRUCTURE MANAGEMENT IN
PRACTICE
ANSWERS TO QUESTIONS:
1. Leverage is the use of assets and liabilities with fixed costs in order to increase the returns to a
firm's common stockholders.
2. a . Fixed costs are operating costs that are independent of sales levels in the short-run. These
costs are primarily related to the passage of time. Examples include depreciation, rent,
insurance, lighting and heating costs, property taxes, and the salaries of management.
b. Variable costs are operating costs that move in close relationship to changes in sales. Variable
costs are related to the output produced and sold, rather than the passage of time. Examples
include raw material costs, direct labor costs, and salespersons' commissions.
3. a. Operating leverage is the employment of assets with fixed operating costs in an attempt to
increase operating income (EBIT).
b. Financial leverage is the employment of funds having fixed capital costs in an attempt to
increase EPS.
4. The degree of combined leverage (DCL) is equal to the degree of operating leverage (DOL)
times the degree of financial leverage (DFL). This relationship shows that operating leverage
and financial leverage can be combined in many different ways to achieve a given degree of
combined leverage. High operating leverage can be offset with low financial leverage and vice
versa.
5. Yes. The level of business risk of a firm relates to the variability of that firm's operating
income. Even if a firm has a high degree of operating leverage, it is possible for it to have a
stable level of operating income if prices, sales quantities, and the variable costs of production
and marketing are stable over time.
6. Yes. If a firm has stable sales revenues and stable operating costs over time, the total risk of
the firm will be low. The degree of combined leverage relates changes in EPS to changes in
sales revenues. Thus, if sales revenues are relatively stable and variable operating costs are
also stable, then EPS also will be stable.
7. Use of EBIT-EPS analysis can determine which financing alternative maximizes EPS.
However, it is possible that maximizing EPS results in such a high risk level that the weighted
cost of capital is not minimized, and therefore the value of the firm is not maximized.
8. A firm cannot tell exactly when it is at the optimal capital structure point. However, this is not
a great problem because the optimal capital structure, in practice, is best depicted as a range.
Many companies are able to conclude they are operating near the optimal range as a result of
borrowing nearly as much as they can at reasonable interest rates. Comparison with other
companies in the industry also should help the company determine whether it safely can
increase its proportion of "moderate" debt and reduce its weighted cost of capital. Other
techniques that can provide useful insight include EBIT-EPS analysis and cash insolvency
analysis.
9. A firm should use more debt if it traditionally has been more profitable than the average firm in
the industry, or if its operating income is more stable than the operating income of the average
firm in the industry. If the opposite factors (i.e., less profitable and less stable) are true, the
firm generally should use less debt. This answer assumes that the average firm in the industry
is operating at or near an optimal capital structure.
10. Public utilities typically incur more financial risk than major oil companies because public
utilities have less business risk than major oil companies. In general, the capital markets
permit low business risk firms to incur a larger percentage of debt in their capital structures
than high business risk firms.
11. Cash insolvency analysis is a tool that can be used to analyze the effects of a proposed capital
structure change. Cash insolvency analysis looks at the effects of a worst-case scenario of a
firms cash balances and net cash flows when a firm is faced with a major recession, or
downturn in its business. Cash insolvency analysis permits a manager to compute the
probability of the firm running out of cash in a recession, given the fixed financial charges the
firm faces with alternative capital structures.
SOLUTIONS TO PROBLEMS:
1. a.
Sales
$6,000,000
$6,600,000
$4,500,000
$4,950,000
800,000
800,000
$5,300,000
$5,750,000
EBIT
$700,000
$850,000
60,000
$60,000
$640,000
$790,000
256,000
316,000
$384,000
$474,000
60,000
60,000
$324,000
$414,000
$5.40
$6.90
d. i. DCL = (EPS/EPS)/(Sales/Sales)
DCL = [($6.90-$5.40)/$5.40]/[($6,600,000 - $6,000,000) / $6,000,000]
= 2.778
ii. DCL = (Sales - Variable costs) / [EBIT - I - Dp/(1 - T)]
DCL = ($6,000,000-$4,500,000) / [($700,000 - $60,000
-$60,000)/(1-.4)] = 2.778
iii. DCL = DOL x DFL = 2.143 x 1.2963 = 2.778
iv. From a base sales level of $6,000,000, each 1 percent change in sales results in a 2.778
percent change in EPS, in the same direction as the sales change.
$3,000,000 = 1.875
(iii)
c. DCL = 3.13, therefore a 15% increase in sales will yield a 15% x 3.13 = 47% increase in
Alexander's EPS next year. Next year's EPS is forecast to be (1 + .47) x $4 = $5.88.
d. Sales ($15,000,000 x 1.15) =
$17,250,000
$10,781,250
2,625,000
$13,406,250
EBIT
$3,843,750
Less: Interest
Earnings before taxes
Less: Income taxes (T = .444444. . . )
Earnings after taxes
750,000
$3,093,750
1,375,000
$1,718,750
250,000
$1,468,750
3. a. Sales = $3,000,000
Variable costs = 0.5 x $3,000,000 = $1,500,000
EBIT = Sales - Variable costs - Fixed costs
= $3,000,000 - $1,500,000 - $900,000 = $600,000
Interest = .125($2,400,000) = $300,000
DCL = ($3,000,000 - $1,500,000) / ($600,000 - $300,000)
$5.88
= 5.0
b. Sales = 1.1 x $3,000,000 = $3,300,000
Variable costs = .475 x $3,300,000 = $1,567,500
EBIT = $3,300,000 - $1,567,500 - ($900,000 +$150,000)
= $682,500
Interest = $300,000 + .125($500,000) = $362,500
DCL = ($3,300,000 - $1,567,500) / ($682,500 - $362,500)
= 5.41
c. 5.0 = ($3,300,000 - $1,567,500) / ($682,500 - .125X)
X = $2,688,000
Gibson would have to reduce debt by ($2,900,000 - $2,688,000 or $212,000 in order to
maintain a DCL at 5.0 in 19x2.
4. Sales = P x Q
EBIT = P x Q - F - V x Q, where P = price/unit; F = fixed cost;
V = variable cost/unit
Sales = Sales2 - Sales1 = PQ2 - PQ1 = P(Q2 - Q1)
EBIT = EBIT2 - EBIT1
= (PQ2 - F - VQ2) - (PQ1 - F - VQ1) = (P - V)(Q2 - Q1)
DOL @ "Sales1" = (EBIT/EBIT1) / (Sales/Sales1)
= [(P - V)(Q2 - Q1) / (PQ1 - F - VQ1)] / [P(Q2 - Q1) / PQ1]
= (P - V)Q1 /(PQ1 - F - VQ1) = (PQ1 - VQ1)/(PQ1 - F - VQ1)
= (Sales1 - Variable cost1)/EBIT1
5. a. Sales = $8,000,000
Variable costs = .2($8,000,000) = $1,600,000
Fixed costs = $5,800,000
$500,000)/($500,000)] = 4.0
d. Current EPS:
EBIT
$8.00
Interest
1.40
EBT
$6.60
Tax
2.64
$3.96
Preferred dividends
Earnings available to C.S.
EPS
0.96
$3.00 (million)
$3.00
3.6 = %EPS/-5%
%EPS = -18%
New EPS = $3.00(1 - 0.18) = $2.46
$9.000
Interest
1.360
EBT
$7.640
Tax (@ 35%)
2.674
$4.966
Preferred dividends
Earnings available to C.S.
2.500
$2.466 (million)
EPS
$2.47
16. The probability that EPS will be less than $5 per share is equal to the probability that sales will
be less than $10,000,000:
z = ($10,000,000 - $11,000,000)/$500,000 = -2.0
p(z<-2.0) = 2.28% from Table V
alternative)
alternative)
9 EBIT - 45 = 6 EBIT
3 EBIT = 45
EBIT* = $15
b. Equity Financing:
EBIT = $10
EBIT = $15
EBIT = $25
EBIT
$10
$15
$25
EBT
10
15
25
T @ 40%
10
EAT
15
Shares Outstanding
15
15
15
EPS
$0.40
$0.60
$1.00
EBIT = $10
EBIT = $15
EBIT = $25
EBIT
$10
$15
$25
EBT
$5
$10
$20
T @ 40%
EAT
$3
$6
$12
Shares Outstanding
10
10
10
EPS
$0.30
$0.60
$1.20
Debt Financing:
19. a Expansion:
Rock Island
Davenport
EBIT
$100
$100
32
EBT
$ 68
$ 92
T @ 40%
27.2
36.8
EAT
$ 40.8
$ 55.2
Shares outstanding
30
45
EPS
$1.36
$1.23
Rock Island
Davenport
EBIT
$ 60
$ 60
32
EBT
$ 28
$ 52
T @ 40%
11.2
20.8
EAT
$16.8
$31.2
Shares outstanding
30
45
EPS
$0.56
$0.69
Recession:
b. Rock Island is riskier because of its financial risk. The two stocks have identical business risk.
Rock Island would be expected to have a higher beta.
This example gives approximately equal stock prices for the two companies. Rock Island's
higher EPS is offset by its lower P/E ratio.
Plan 1
Plan 2
EBIT
$6.0
$6.0
1.2
EBT
$6.0
$4.8
T @ 40%
2.4
1.92
EAT
$3.6
$2.88
Shares Outstanding
2.0
1.0
EPS
$1.80
$2.88
1. The plan's effect on the company's stock price (difficult to determine in practice).
2. The capital structure of the parent company.
3. The probability distribution of expected EBIT.
d. Adopt plan 2 if the company can be reasonably sure that EBIT will not drop too much in a
recession. Otherwise, plan 1 appears better. (See Parts e and f below ).
100,000
EBIT* = $170,000
b. Compute the probability that the actual EBIT will be greater than $170,000.
z = ($170,000 - $240,000)/$50,000 = -1.4
From Table V, the probability of a value less than 1.4 standard deviations to the left of the
mean is 8.08%. This is the probability that the equity alternative is superior to the debt
alternative. Thus, the probability that the debt alternative is superior is 91.92% (1.0 - .0808).
c. The probability of negative earnings is the probability that actual EBIT will fall below the loss
level ($126,000).
z = ($126,000 - $240,000)/$50,000 = -2.28
The probability of EBIT falling below the $126,000 loss level is 1.13% from Table V.
22. a.
b. The debt financing alternative should be selected because its average cost is 14.5% pretax,
compared to the 16% after-tax cost of the preferred stock alternative. In other words, the debt
financing alternative results in higher EPS values than the preferred stock financing alternative
at all EBIT levels. The two functions do not cross each other, and, as a result, no indifference
point exists.
23. a. The probability that the equity financing option will result in a higher EPS is equal to the
probability that the EBIT level will be less than $4.0 million. The probability that EBIT
will be less that $4.0 million is computed, as follows:
z = (4.0 - 4.5)/0.6 = -0.83
From Table V, the probability of a value less than 0.83 standard deviations to the left of the
mean is 20.33%.
b. The probability of losing money is the probability that the actual EBIT will fall below the $3
million level.
z = ($3.0 - $4.5)/$0.6 = -2.50
From Table V, the probability of EBIT falling below the $3.0million level is 0.62%, i.e., quite
low.
25. a. The probability that the equity financing option will result in a higher EPS is equal to the
probability that the EBIT level will be less than $500,000. The probability that EBIT will
be less than $500,000 is computed, as follows:
z = ($500,000 - $620,000)/$190,000 = -0.63
From Table V, the probability of a value less than 0.63 standard deviations to the left of the
mean is 26.43%. Thus, the probability that the equity alternative will be superior to the debt
alternative is about 26%.
b. The probability that the firm will incur losses is the probability that the actual EBIT will fall
below the $200,000 level.
z = ($200,000 - $620,000)/$190,000 = -2.21
From Table V, the probability of EBIT falling below the
b. The probability that Alternative II will result in higher EPS than Alternative I is the probability
27. a
29. a
million.
27.43%.
Hence the increase in the probability of incurring a
loss is 27.43% - 13.57 % = 13.86%