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Financial Leverage and Capital Structure Policy

17. Financial Leverage and Capital Structure Policy. Questions and Problems. 1. EBIT and Leverage

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Financial Leverage and Capital Structure Policy

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  1. 17 Financial Leverage and Capital Structure Policy

  2. Questions and Problems • 1. EBIT and Leverage • Money SpA, has no debt outstanding and a total market value of €150,000. Earnings before interest and taxes, EBIT, are projected to be €15,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 60 percent lower. Money is considering a €60,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem.

  3. a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession. • b. Repeat part (a) assuming that Money goes through with recapitalization. What do you observe?

  4. 1.a. A table outlining the income statement for the three possible states of the economy is shown below. The EPS is the net income divided by the 2,500 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy.

  5. b. If the company undergoes the proposed recapitalization, it will repurchase: • Share price = Equity / Shares outstanding • Share price = €150,000/2,500 • Share price = €60 • Shares repurchased = Debt issued / Share price • Shares repurchased =€60,000/€60 • Shares repurchased = 1,000

  6. The interest payment each year under all three scenarios will be: • Interest payment = €60,000(.05) = €3,000 • The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization.

  7. 2. EBIT, Taxes, and Leverage • Repeat parts (a) and (b) in Problem 1 assuming Money has a tax rate of 35 percent.

  8. a. A table outlining the income statement with taxes for the three possible states of the economy is shown below. The share price is still €60, and there are still 2,500 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy.

  9. b. A table outlining the income statement with taxes for the three possible states of the economy and assuming the company undertakes the proposed capitalization is shown below. The interest payment and shares repurchased are the same as in part b of Problem 1.

  10. Notice that the percentage change in EPS is the same both with and without taxes.

  11. 3. ROE and Leverage • Suppose the company in Problem 1 has a market-to-book ratio of 1.0. • a. Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes. • b. Repeat part (a) assuming the firm goes through with the proposed recapitalization. • c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent.

  12. 3.a.Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE: • ROE = NI/€150,000 • The ROE for each state of the economy under the current capital structure and no taxes is:

  13. The second row shows the percentage change in ROE from the normal economy.

  14. b. If the company undertakes the proposed recapitalization, the new equity value will be: • Equity = €150,000 – 60,000 • Equity = €90,000 • So, the ROE for each state of the economy is: • ROE = NI/€90,000

  15. c. If there are corporate taxes and the company maintains its current capital structure, the ROE is:

  16. If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each state of the economy is:

  17. Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage change in ROE is also the same with or without taxes.

  18. 4. Break-Even EBIT • Shantou Beverage is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Shantou would have 150,000 shares of stock outstanding. Under Plan II, there would be 60,000 shares of stock outstanding and 15 million yuan in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. • a. If EBIT is 2 million yuan, which plan will result in the higher EPS? • b. If EBIT is 7 million yuan, which plan will result in the higher EPS? • c. What is the break-even EBIT?

  19. 4.a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be: • EPS = CNY2,000,000/150,000 shares • EPS = CNY13.33

  20. Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so: • NI = CNY2,000,000 – .10(CNY15,000,000) • NI = CNY500,000

  21. And the EPS will be: • EPS = CNY500,000/60,000 shares • EPS = CNY8.33 • Plan I has the higher EPS when EBIT is CNY2,000,000.

  22. b. Under Plan I, the net income is CNY7,000,000 and the EPS is: • EPS = CNY7,000,000/150,000 shares • EPS = CNY46.67 • Under Plan II, the net income is: • NI = CNY7,000,000 – .10(CNY15,000,000) • NI = CNY5,500,000

  23. And the EPS is: • EPS = CNY5,500,000/60,000 shares • EPS = CNY91.67 • Plan II has the higher EPS when EBIT is CNY7,000,000.

  24. c. To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is: • EBIT/150,000 = [EBIT – .10(CNY15,000,000)]/60,000 • EBIT = CNY2,500,000

  25. 5. M&M and Stock Value • In Problem 4, use M&M Proposition I to find the price per share of equity under each of the two proposed plans. What is the value of the firm?

  26. 5. We can find the price per share by dividing the amount of debt used to repurchase shares by the number of shares repurchased. Doing so, we find the share price is: • Share price = CNY15,000,000/(150,000 – 60,000) • Share price = CNY166.67 per share • The value of the company under the all-equity plan is: • V = CNY166.67(150,000 shares) = CNY2,500,500

  27. And the value of the company under the levered plan is: • V = CNY166.67(60,000 shares) + CNY15,000,000 debt = CNY2,500,200

  28. 6. Break-Even EBIT and Leverage • Malang Fabric Manufacturing is comparing two different capital structures. Plan I would result in 1,100 shares of stock and 17 million rupiahs in debt. Plan II would result in 900 shares of stock and 28 million rupiahs in debt. The interest rate on the debt is 10 percent. • a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be 10 million rupiahs. The all-equity plan would result in 1,400 shares of stock outstanding. Which of the three plans has the highest EPS? The lowest?

  29. b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Is one higher than the other? Why? • c. Ignoring taxes, when will EPS be identical for Plans I and II? • d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 40 percent. Are the break-even levels of EBIT different from before? Why or why not?

  30. Plan II has the highest EPS; the all-equity plan has the lowest EPS.

  31. b. The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is calculated as: • EPS = (EBIT – RDD)/Shares outstanding • This equation calculates the interest payment (RDD) and subtracts it from the EBIT, which results in the net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the interest term is zero. To find the breakeven EBIT for two different capital structures, we simply set the equations equal to each other and solve for EBIT.

  32. The breakeven EBIT between the all-equity capital structure and Plan I is: • EBIT/1,400 = [EBIT – .10(INR17,000,00)]/1,100 • EBIT = INR7,933,333 • And the breakeven EBIT between the all-equity capital structure and Plan II is: • EBIT/1,400 = [EBIT – .10(INR28,000,000)]/900 • EBIT = INR7,840,000

  33. c. Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT, we get: • [EBIT – .10(INR17,000,000)]/1,100 = [EBIT – .10(INR28,000,000)]/900 • EBIT = INR7,750,000

  34. Plan II still has the highest EPS; the all-equity plan still has the lowest EPS. • We can calculate the EPS as: • EPS = [(EBIT – RDD)(1 – tC)]/Shares outstanding • This is similar to the equation we used before, except now we need to account for taxes. Again, the interest expense term is zero in the all-equity capital structure.

  35. So, the breakeven EBIT between the all-equity plan and Plan I is: • EBIT(1 – .40)/1,400 = [EBIT – .10(INR17,000,000)](1 – .40)/1,100 • EBIT = INR7,933,333 • The breakeven EBIT between the all-equity plan and Plan II is: • EBIT(1 – .40)/1,400 = [EBIT – .10(INR28,000,000)](1 – .40)/900 • EBIT = INR7,840,000

  36. And the breakeven between Plan I and Plan II is: • [EBIT – .10(INR17,000,000)](1 – .40)/1,100 = [EBIT – .10(INR28,000,000)](1 – .40)/900 • EBIT = INR7,750,000 • The break-even levels of EBIT do not change because the addition of taxes reduces the income of all three plans by the same percentage; therefore, they do not change relative to one another.

  37. 7. Leverage and Stock Value • Ignoring taxes in Problem 6, what is the price per share of equity under Plan I? Plan II? What principle is illustrated by your answers?

  38. 7. To find the value per share of the stock under each capitalization plan, we can calculate the price as the value of shares repurchased divided by the number of shares repurchased. So, under Plan I, the value per share is: • P = INR11,000,000/200 shares • P = INR55,000 per share

  39. And under Plan II, the value per share is: • P = INR28,000,000/500 shares • P = INR56,000 per share

  40. 8. Homemade Leverage Valencia Items, a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 percent debt. Currently, there are 2,000 shares outstanding and the price per share is 70 euros. EBIT is expected to remain at 16,000 euros per year forever. The interest rate on new debt is 10 percent, and there are no taxes.

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