Solution manual financial management 10e by keown chapter 16

                                                                                                                                                                                                               CHAPTER 16 Planning the Firm's Financing Mix                                                                                                                                                                                                                CHAPTER ORIENTATION This chapter concentrates on the way the firm arranges its sources of funds. The cost of capital   –   capital   structure   argument   is   highlighted   A   moderate   view   on   the   effect   of financial leverage use on the composite cost of capital is adopted. Later, techniques useful to the   financial   officer   faced   with   the   determination   of   an   appropriate   financing   mix   are described CHAPTER OUTLINE I Introduction A B II A distinction between financial structure and capital structure Financial structure is the mix of items on the right-hand side of the firm's balance sheet Capital structure is the mix of long-term sources of funds The main focus will be capital structure management and not the appropriate maturity composition of the sources of funds The objective of capital structure management is to mix the permanent sources of funds in a manner that will maximize the company's common stock price This proper mix of fund sources is referred to as the optimal capital structure A glance at capital structure theory A The cost of capital – capital structure argument may be characterized by this question: Can the firm affect its overall cost of funds by varying the mixture of financing sources used? B If the firm's cost of capital can be affected by the degree to which it uses financial leverage, then capital structure management is important 136 C III IV V The analytical discussion revolves around a simplified version of the basic dividend valuation model It assumes (a) cash dividends paid will not change over the infinite holding period, and (b) the firm retains none of its current earnings The analytical setting for the discussion of capital structure theory assumes (a) corporate income is not subject to any taxation, (b) capital structures consist of only stocks and bonds, (c) the expected values of all investors' forecasts of the future levels of net operating income for each firm are identical, and (d) securities are traded in perfect or efficient financial markets Extreme position 1: The Independence Hypothesis (NOI Theory) A When business income is not subject to taxation, the firm's composite cost of capital and common stock price are both independent of the degree to which the firm chooses to use financial leverage B Total market value of the firm's outstanding securities is unaffected by the arrangement of the right-hand side of the balance sheet C The independence hypothesis rests upon what is called the net operating income (NOI) approach to valuation D The use of a greater degree of financial leverage may result in greater earnings and dividends, but the firm's cost of common equity will rise at precisely the same rate as the earnings and dividends Extreme position 2: The Dependence Hypothesis (NI Theory) A The dependence hypothesis suggests that both the weighted cost of capital and the firm's common stock price are affected by the firm's use of financial leverage B Regardless of the firm's use of debt financing, both its cost of debt and equity capital will not be affected by capital structure adjustments C The cost of debt is less than the cost of common equity, implying greater financial leverage use will lower the weighted cost of capital indefinitely D The dependence hypothesis rests upon what is called the net income (NI) approach to valuation A moderate position: Corporate Income is Taxed and Firms May Fail A Admits to the following facts: (1) interest expense is tax deductible, and (2) the probability of suffering bankruptcy costs is directly related to the use of financial leverage 137 B When interest expense is tax deductible, the sum of the cash flows that the firm could pay to all contributors of corporate capital is affected by its financing mix This is not the case when an environment of no corporate taxation is presumed VI The amount of the tax shield on interest may be calculated as Tax shield = r (M) (t) where r = the interest rate paid on outstanding debt M = the principal amount of the debt t = the firm's tax rate This position presents the view that the tax shield must have value in the marketplace Therefore, financial leverage affects firm value, and it must also affect the cost of corporate capital C There is some point at which the expected cost of default is large enough to outweigh the tax shield advantage of debt financing At that point, the firm will turn to common equity financing D The determination of the firm's financing mix is centrally important to both the financial manager and the firm's owners Firm Value, Agency Costs, the Static Trade-off Theory, and the Pecking Order Theory A B C To ensure that agent-managers act in the stockholders' best interest requires Proper incentives to so through compensation plans and perquisites Decisions that are monitored through bonding, auditing financial statements, limiting decisions, and reviewing the perquisites Agency problems stem from conflicts of interest between firm management and owners; capital structure management encompasses a natural conflict between stockholders and bondholders To reduce the conflict of interest, creditors and stockholders may agree to include several protective covenants in the bond contract Monitoring costs should differ in direct proportion to low or high levels of leverage Static trade-off theory distinguished from pecking order theory Static trade-off theory provides for the identification of a precise optimum financing mix This financing mix should logically determine the firm's targeted leverage ratio Static trade-off theory "prices" both expected financial distress costs and agency costs 138 VII VIII Pecking order theory suggests that firm's finance projects within a well-defined hierarchy that begins with internally generated funds and ends with new common equity (the least desired funds source) Thus, pecking order theory provides no precisely defined target leverage ratio since typical leverage metrics just reflect the firm's cumulative external financing needs over time Agency costs, free cash flow, and capital structure A Free cash flow, as defined by Professor Michael C Jensen, is the "cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital." B Like the pecking order theory, the free cash flow theory of capital structure does not give a precise solution that determines the firm's optimal financing mix C The free cash flow theory does provide a framework and rationale for justifying why shareholders and their boards of directors might use more debt (financial leverage) to control management behavior and decisions D The upshot of all of these theories and perspectives is that the determination of the firm's financing mix is centrally important to the financial manager The firm's stockholders are indeed affected by capital structure decisions; these decisions affect the firm's stock price Basic tools of capital structure management A The use of financial leverage has two effects on the earnings stream flowing to common stockholders: (l) the added variability in the earnings per share (EPS) stream that accompanies the use of fixed-charge securities and (2) the level of EPS at a given earnings before interest and taxes level (EBIT) associated with a specific capital structure B The objective of EBIT-EPS analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen A graphic or algebraic analysis can be used By allowing for sinking fund payments, the analysis can focus upon uncommitted earnings per share EBIT-EPS analysis considers only the level of the earnings stream and ignores the variability in it C Comparative leverage ratios involve the computation of various balance sheet leverage ratios and coverage ratios D The use of industry norms in conjunction with comparative leverage ratios can aid in arriving at an appropriate financing mix 139 E IX X Cash flow analysis (company-wide cash flows) is the study of projected impact of capital structure decisions on corporate cash flows According to this tool, the appropriate level of financial leverage is reached when the chance of running out of cash is exactly equal to that which management will assume An underlying assumption is that management's risk-bearing preferences are conditioned by the investing marketplace The Multinational Firm: Beware of Currency Risk A Currency risk exists for firms that have sales in non-U.S markets B Earnings must be converted from foreign currencies into dollars and reported in the firm’s financial statements C Variations in exchange rates impact firm’s overall earnings This can impact stock price, negatively if foreign currency depreciated in value against the dollar or positively if the currency appreciated in value Firms with high exposure to currency risk may choose to minimize other financial risk How financial managers use this material A The opinions and practices of financial executives reinforce the major topics covered in this chapter B Target debt ratios are widely used by financial officers C Executives operationalize debt capacity in different ways The most popular approach is to define the firm's debt capacity as a target percent of total capitalization D Changes in the aggregate business environment, known as business cycles, affect capital structure decisions Some phases of the cycle favor debt financing over equity financing; in other phases equity financing is preferred E The single most important factor that should affect the firm's financing mix is the underlying nature of the business in which it operates A firm's business risk must be carefully assessed ANSWERS TO END-OF-CHAPTER QUESTIONS 16-1 (a) Financial structure: the mix of all items that appear on the right-hand side of the company's balance sheet (b) Capital structure: the mix of long-term funds used by the firm (c) Optimal capital structure: the mix of long-term funds that will minimize the composite cost of capital for raising a given amount of funds 140 (d) Debt capacity: the maximum proportion of debt that the firm can include in its capital structure and still maintain its lowest composite cost of capital 16-2 The decision to use financial leverage by the firm affects both the level and variability of the EPS flowing to the common stockholders EBIT-EPS analysis deals only with the level (amount) of EPS available under a given financing plan The variability in the earnings stream associated with the plan is ignored EBITEPS analysis then disregards the riskiness inherent to a particular financing alternative 16-3 The objective of capital structure management is to mix the permanent sources of funds used by the firm in a manner that will maximize the company's common stock price 16-4 Balance sheet leverage ratios compare the firm's use of funds supplied by creditors to those supplied by owners The inputs to these metrics come from the company's balance sheet Coverage ratios relate the earnings or cash flow amounts that are available for servicing financing contracts to the associated financing costs The inputs to computing coverage ratios generally come from the company's income statement At times, footnotes to the financial statements might have to be consulted to complete some coverage ratios Table 16-7 in the text identifies the calculation methods for several popular leverage ratios 16-5 If revenues from sales are highly volatile, then other things being equal, cash flows will be volatile This would make it difficult to meet, on a timely basis, a large amount of fixed financing costs Because of this, a high degree of financial risk will be avoided by firms that operate in industries which experience large sales fluctuations 16-6 If the firm's overall cost of capital is not affected by varying the mixture of financing sources used, then capital structure management would be a meaningless activity Likewise, this infers that if the value of the firm is independent of the firm's financing mix, then capital structure management is a sterile process 16-7 Within the realm of capital structure theory, the independence hypothesis offers that both common stock price and the composite cost of capital are not affected by the firm's use of financial leverage This presumes that interest expense is not tax deductible 16-8 Professors Modigliani and Miller are leading proponents of this theory 16-9 This means that the shape of the firm's composite cost of capital curve is saucershaped, or U-shaped, with respect to the use of financial leverage Over moderate degrees of leverage use, the overall cost of capital decreases Throughout the optimal range of leverage use, the cost of capital curve is relatively flat At excessive degrees of leverage use, the overall cost of capital rises The result is a saucer shaped cost of capital curve 16-10 The EBIT-EPS indifference point is the level of EBIT that will equate EPS regardless of the financing plan ultimately chosen from a set of two alternatives 16-11 UEPS is the earnings available to the common shareholders minus sinking fund payments that have been honored 141 16-12 Industry norms for the various balance sheet leverage ratios and coverage ratios only provide rough guidelines for the design of the firm's financing mix Norms are usually averages or some other measure of central tendency Few firms in reality will have the same operating characteristics as a hypothetical "normal" firm Thus, norms are best used on an "exception" basis That is, if the firm's capital structure ratios differ widely from the norms, then a defensible explanation for that condition should be available 16-13 Free cash flow is the cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital 16-14 The free cash flow theory of capital structure suggests that management works "best" under the threat of financial failure By increasing the use of leverageinducing instruments in the firm's capital structure, then shareholders will enjoy increased control over management This, in turn, reduces the agency costs of free cash flow 16-15 During the 1980s several studies suggest that financial leverage use increased substantially compared to the 1970s This trend began reversing in the early 1990s as the market for common equities improved 16-16 It makes sense for financial managers to be familiar with the business cycle because financial market and product market conditions can change abruptly during the cycle This means that company policies and decisions may differ over different phases (say expansion or contraction) of the cycle 16-17 Financial managers clearly favor the use of internally generated equity in the financing of capital budgets SOLUTIONS TO END-OF-CHAPTER PROBLEMS Solutions to Problem Set A 16-1A a FC = FC = FC = b Interest + Sinking Fund $15 million ($15 Million) (.18) + 30 years $2,700,000 + $500,000 = $3,200,000 CBr = Cb0 + NCFr – FC Where: CB0 = $2,000,000 = $3,200,000 FC and NCFr = $4,950,000 - $4,000,000 = $950,000 so, CBr = $2,000,000 + $950,000 - $3,200,000 CBr = -$250,000 142 c We see that the company has a preference for a $2 million cash balance The combination of the recessionary period and the proposed issue of bonds would put the firm’s recessionary cash balance (CBr) at -$250,000 The combination of the negative number and the statement that the firm likes a cash balance of $2 million suggest strongly that the proposed bond issue be postponed 16-2A The following formula can be used to solve for the amount of cash collections on sales, CS, required to provide the desired end of year cash balance: CBr = C0 + (CS + OR) - (Pa + RM + En) - FC Solving for the required minimum cash receipts from sales: CS = CBr - {C0 + OR - (Pa + RM + En) - FC} then, simplifying: CS = CBr - C0 - OR + Pa + RM + En + FC where CBr C0 OR Pa RM En FC = = = = = = = desired cash balance at end of recessionary period = cash balance at beginning of period = other cash receipts (as percent of sales receipts) = payroll expenditures (as percent of sales receipts) = raw material payments (as percent of sales receipts) = total nondiscretionary expenditures = fixed financial charges = $200,000 $200,000 5% 30% 25% $500,000 $140,000 thus CS = {CBr - C0 + En + FC} / {1 - (-OR% + Pa% + RM%)} CS =  $200,000  $200,000  $500,000  $140,000 1  ( 5%  30%  25%) = $1,280,000 PROOF: CBr = C0 + (CS + OR) - (Pa + RM + En) - FC CBr = $200,000 + ($1,280,000 + 05 x $1,280,000) - (.30 x $1,280,000 + 25 x $1,280,000 + $500,000) - $140,000 CBr = $200,000 + $1,280,000 + $64,000 - $384,000 - $320,000 - $500,000 - $140,000 CBr = $200,000 143 16-3A At the EBIT indifference level: EPS (All Debt Plan) = EPS (Debt and Equity Plan) [(EBIT  I)(1  t)  P  SF] SAllDebt = [(EBIT  I)(1  t)  P  SF] SDebtEquity that is, [(EBIT  $90,000)(1  35)  $50,000] 100,000 [(EBIT  $32,000)(1  35)  $20,000] (100,000  30,000) = 65EBIT  $108,500 10 = 65EBIT  $40,800 13 EBIT = $514,103 (EBIT  I)(1  t)  P Ss = (EBIT  I)(1  t)  P Sb (EBIT  $0)(1  0.5)  1,000,000 = (EBIT  $600,000)(1  0.5)  700,000 0.5EBIT 10 = 0.5EBIT  $300,000 EBIT = 16-4A (a) (b) Plan A $2,000,000 $2,000,000 1,000,000 $1,000,000 $1,000,000 $ 1.00 EBIT Interest EBT Taxes NI P EAC EPS (c) $2,000,000 See following analysis chart 144 Plan B $2,000,000 600,000 $1,400,000 700,000 $ 700,000 $ 700,000 $ 1.00 (d) Since $2,400,000 exceeds $2,000,000, the levered plan (Plan B) will provide for higher EPS $2 1.5 Plan A Plan B 1.0 $1.0 Indif level 0.5 $600,000 $ Mi l $ Mi l 16-5A (a) ($30) (900,000 shares) = $27,000,000 (b) Kc = Dt E $6 = t = = 20% Po Po $30 In the all equity firm Kc = Ko, Thus, Ko = 20% (c) Kc = (1) $6.21 = 20.7% $30.0 EBIT - Interest EAC ÷ = Dt $5,400,000 120,000 $5,280,000 850,000 $6.21 shares* *$1,500,000 ÷ $30 = 50,000 shares retired (2) $6.21  $6.00 = 0.035 or 3.5% $6.00 145 $ Mi l $ Mi l (c) 16-15A (a) (b) (c) 16-16A (a) (b) The firm ordinarily carries a $500,000 cash balance This analysis shows that during a tight economic period the firm's cash balance (CB r) could fall to as low as $150,000 Management might well decide not to issue the proposed bonds Firm C appears to be excessively levered Both its debt ratio and burden coverage ratio are unfavorable relative to the industry norm The firm's price/earnings ratio is significantly lower (6 versus 10) than the industry norm Firm B The investing market place seems to place more weight on coverage ratios than balance sheet leverage measures Thus, Firm B's price/earnings ratio exceeds that of Firm A Firm Y seems to be most appropriately levered Its price/earnings ratio exceeds that of both Firms X and Z The first financial leverage effect refers to the added variability in the earnings-per-share stream caused by the firm's use of leverage-inducing financial instruments The second financial leverage effect concerns the level of earnings per share at a specific EBIT associated with a specific capital structure Beyond some critical EBIT level, earnings per share will be higher if more (rather than less) leverage is used Based on the tabular data in this problem the market seems to be weighing the second leverage effect more heavily Thus, Firm Z seems to be underlevered 16-17A (a) ($20) (1,000,000 shares) = $20,000,000 (b) Kc = Dt E $5 = t = = 25% Po Po $20 In the all equity firm Kc = Ko, thus, Ko = 25% (c) Kc = (1) (2) $5.179 = 25.895% $20.0 EBIT - Interest EAC ÷ = Dt $5,000,000 80,000 $4,920,000 950,000 $5.179 $5.179  $5.000 = 0.0358 or 3.58% 5.000 (3) 25.895%  25.000% = 0.0358 or 3.58% 25.000% (4) 19 (25.895) + (8.00) = 25.0% 20 20 152 16-18A (a) ($40) (600,000 shares) = $24,000,000 (b) Kc = Dt E $7 = t = = 17.5% Po Po $40 In the all equity firm Kc = Ko, thus, Ko = 17.5% (c) Kc = $7.13 = 17.825% $40.000 (1) EBIT - Interest EAC ÷ = Dt $4,200,000 100,000 $4,100,000 575,000 $7.13 shares* *$1,000,000 ÷ $40 = 25,000 shares retired 16-19A (a) (2) $7.13  $7.00 = 1.86% $7.00 (3) 17.825%  17.500% = 1.86% 17.500% (4) 23 (17.825%) + (10.00%) = 17.5% 24 24 Plan B will always dominate Plan C, the preferred stock alternative, by 0.5 ($1,800)/8,000 shares or $0.1125 a share Thus, only alternative A versus B and A versus C need be evaluated Those calculations appear below Plan A versus Plan B (EBIT  $0)(1  0.5)  (EBIT  $1,800)(1  0.5) = 10,000 8,000 EBIT = $9,000 Plan A versus Plan C (EBIT  $0)(1  0.5)  (EBIT  0)(1  0.5)  $1,800 = 10,000 8,000 EBIT = $18,000 (b) Since long-term EBIT is forecast to be $22,000, the data favor use of financing alternative B, the bond plan This is well above the A versus B indifference level of $9,000 153 SOLUTION TO INTEGRATIVE PROBLEM PART I EBIT-EPS ANALYSIS At the EBIT indifference level: EPS (LLP) = EPS (HLP) [(EBIT  I)(1  t)  P] SLLP = [(EBIT  I)(1  t)  P] SHLP [(EBIT  $220,000)(1  35)  0] 400,000 = [(EBIT  $840,000)(1  35)  0] 200,000 65EBIT  $143,000 40 = 65EBIT  $546,000 20 EBIT = $1,460,000 See graph on following page The analytical income statement demonstrating that EPS (LLP) = EPS (HLP) is as follows: EBIT Interest EBT Taxes (35%) NI P EAC ÷ # of common shares EPS LLP $1,460,000 220,000 $1,240,000 434,000 $806,000 HLP $1,460,000 840,000 $620,000 217,000 $403,000 $806,000 400,000 $2.015 $403,000 200,000 The expected long-term EBIT of $1,300,000 does not exceed the EBIT indifference level Consequently, the low leveraged plan, LLP, will produce the higher EPS To determine the financing plan that should be recommended, it is necessary to compute the expected stock price under each plan To so, EPS is computed first, then the projected stock price is computed, as follows: 154 EBIT-EPS INDIFFERENCE CHART EPS in DOLLARS $4.000 $3.500 HLP $3.000 $2.500 LLP $2.01 $2.000 411 $1.500 EBIT Indifference Level $1,460, 000 $1.000 $0.500 $0.000 $0 $200,000 $400,000 $600,000 $800,000 $1,000,000 EBIT in Dollars $1,200,000 $1,400,000 $1,600,000 $1,800,000 $2,000,000 LLP $1,300,000 220,000 $1,080,000 378,000 $702,000 $702,000 400,000 $1.755 18 $31.590 EBIT Interest EBT Taxes (35%) NI P EAC ÷ Number of common shares EPS x P/E ratio = Projected stock price HLP $1,300,000 840,000 $460,000 161,000 $299,000 $299,000 200,000 $1.495 14 $20.930 The preferred plan is the one with the higher projected stock price, namely LLP It also can be noted that the greater riskiness of HLP results in the market applying a lower price/earnings multiple to the expected EPS To find the P/E ratio that equates the stock prices for both plans at the given EBIT level, it is only necessary to solve the formula, EARNINGS x P/E RATIO = PRICE, as follows: Price [under LLP] ÷ Earnings [under HLP] = P/E Ratio PART $31.59 1.495 21.130 RECESSIONARY CASH FLOW ANALYSIS Total fixed financial charges, FC, the firm would have to pay next year are computed using the following formula: FC = interest expense + sinking fund/year where Proposed dollar amount of new bonds x Interest rate = Interest expense LLP $2,000,000 x 11% $220,000 HLP $6,000,000 x 14% $840,000 Proposed dollar amount of new bonds x Sinking fund requirement/year = Sinking fund/year $2,000,000 x 10% $200,000 $6,000,000 x 10% $600,000 $420,000 $1,440,000 thus, FC = 158 The cash balance at the end of the recessionary year, CBr, is computed using the following formula: CBr = C0 + (CS + OR) - (Pa + RM + Te + En) - FC where C0 = Cash balance at beginning of period CS = Cash collections from sales OR = Miscellaneous cash receipts Pa = Payroll expenditures RM = Raw material payments Te = Estimated tax payments En = All other nondiscretionary cash outlays FC (as computed) thus, CBr = = = = = = = = = LLP $500,000 $4,000,000 $200,000 $1,500,000 $1,000,000 $265,000 $700,000 $420,000 $815,000 HLP $500,000 $4,000,000 $200,000 $1,500,000 $1,000,000 $54,000 $700,000 $1,440,000 $6,000 The firm prefers to maintain a cash balance of $500,000 Yet, the combined effect of a recession and the costs associated with the proposed new debt would result in recessionary cash balances of $815,000 and $6,000 for LLP and HLP, respectively Consequently, the lower leverage plan, LLP, is recommended over the higher leverage plan, HLP Solutions to Problem Set B 16-1B The following formula can be used to solve for the amount of cash collections on sales, CS, required to provide the desired end of year cash balance: CBr = C0 + (CS + OR) - (Pa + RM + En) - FC Solving for the required minimum cash receipts from sales: CS = CBr - {C0 + OR - (Pa + RM + En) - FC} then, simplifying: CS = CBr - C0 - OR + Pa + RM + En + FC 159 where CBr C0 OR Pa RM En FC = = = = = = = desired cash balance at end of recessionary period = cash balance at beginning of period = other cash receipts (as percent of sales receipts) = payroll expenditures (as percent of sales receipts) = raw material payments (as percent of sales receipts) = total nondiscretionary expenditures = fixed financial charges = $400,000 $400,000 5% 40% 20% $500,000 $300,000 thus CS = {CBr - C0 + En + FC} / {1 - (-OR% + Pa% + RM%)} CS =  $40,000  $400,000  $5000,000  $300,000 1  ( 5%  40%  20%) = $1,777,778 PROOF: CBr = C0 + (CS + OR) - (Pa + RM + En) - FC CBr = $400,000 + ($1,777,778 + 05 x $1,777,778) - (.40 x $1,777,778 + 20 x $1,777,778 + $500,000) - $300,000 CBr = $400,000 + $1,777,778 + $88,889 - $711,111 - $355,556 $500,000 - $300,000 CBr = $400,000 16-2B At the EBIT indifference level: EPS (All Debt Plan) = EPS (Debt and Equity Plan) = [(EBIT  I)(1  t)  P  SF] SDebt & Equity = [(EBIT  $48,000)(1  35)  $30,000] (100,000  70,000) 65EBIT  $230,000 10 = 65EBIT  $61,200 17 EBIT = $724,835 that is, [(EBIT  I)(1  t)  P  SF] SAllDebt [(EBIT  $200,000)(1  35)  $100,000] 100,000 160 16-3B (a) (b) (c) (EBIT  0)(1  0.34) 150,000 shares = (EBIT  $220,000)(1  0.34) 50,000 shares 0.66EBIT 15 = 0.66EBIT  $145,200 EBIT = $330,000 Since $450,000 exceeds the indifference level of $330,000 from part (a), the levered alternative (Plan B) will generate the higher EPS Here we compute EPS for each financing plan, apply the relevant price/earnings ratios, and, thereby, forecast a common stock price for each plan Thus, we have: Plan A $450,000 $450,000 153,000 $297,000 _0 $297,000 150,000 $ 1.98 19 $37.62 EBIT Interest EBT Taxes (34%) NI P EAC ÷ No of common shares EPS x P-E ratio = Projected Stock Price Plan B $450,000 220,000 $230,000 78,200 $151,800 _0 $151,800 50,000 $ 3.036 12.39 $37.62 The added riskiness of Plan B, owing to the use of financial leverage, is reflected in the lower P-E ratio associated with Plan B (i.e., 12.39x versus 19x for Plan A) The rational investor will prefer Plan A (unlevered) as the same projected stock price ($37.62) can be obtained with a lower level of risk exposure 16-4B (a) (EBIT  0)(1  0.34) 80,000 shares = (EBIT  $320,000)(1  0.34) 50,000 shares 66EBIT 80 = 66EBIT  $211,200 50 EBIT = $853,333 (b) Plan A $853,333 $853,333 290,133 $563,200 80,000 $7.04 EBIT Interest EBT Taxes (34%) EAC ÷ No of common shares EPS 161 Plan B $853,333 320,000 $533,333 181,333 $352,000 50,000 $7.04 16-5B (a) (EBIT  $0)(1  0.5) 75,000 shares = (EBIT  $140,000)(  0.5) 50,000 shares 0.5EBIT 75 = 0.5EBIT  $70,000 50 EBIT = $420,000 (b) Plan A $420,000 $420,000 210,000 $210,000 $210,000 75,000 $ 2.80 EBIT Interest EBT Taxes (50%) NI P EAC ÷ No of Common Shares EPS (c) (d) Plan B $420,000 140,000 $280,000 140,000 $140,000 $140,000 50,000 $ 2.80 Since $750,000 exceeds the calculated indifference level of $420,000, the levered plan (Plan B) will generate the higher EPS To solve this part of the problem, compute EPS under each financial alternative Then apply the relevant price-earnings ratio for each plan An associated common stock price for each plan can then be forecast This follows Plan A Plan B EBIT $750,000 $750,000 Interest 140,000 EBT $750,000 $610,000 Taxes (50%) 375,000 305,000 NI $375,000 $305,000 P 0 EAC $375,000 $305,000 ÷ No of Common Shares 75,000 50,000 EPS $ 5.00 $ 6.10 × P-E Ratio 12 9.836 = Projected Stock Price $60.00 $60.00 Riskiness is reflected in a lower P-E ratio for Plan B of 9.836 versus that of 12 for Plan A (the all common equity plan) The decision now can logically shift to Plan A (unlevered) The investors obtain the same stock price of $60.00 under both plans There is less risk in Plan A, so it would be preferable 162 16-6B (a) FC = Interest + Sinking Fund ($11million) = ($11 million) (.16) + 20yr = $1,760,000 + $550,000 = $2,310,000 FC FC (b) CBr = CB0 + NCFr - FC where: (c) 16-7B.(a) CB0 = $500,000 FC = $2,310,000 and, NCFr = $3,800,000 - $3,600,000 = $200,000 so, CBr = $500,000 + $200,000 - $2,310,000 CBr = - $1,610,000 We see that the company has a preference for a $500,000 cash balance The combination of the recessionary period and the proposed issue of bonds would put the firm's recessionary cash balance (CB r) at -$1,610,000 The combination of this negative number and the statement that the firm likes a cash balance of $500,000 suggests strongly that the proposed bond issue be postponed (EBIT  $0)(1  0.4) 75,000 = (EBIT  $240,000)(  0.4) 55,000 0.6EBIT 75 = 0.6EBIT  $144,000 55 EBIT = $900,000 (b) Plan A $900,000 $900,000 360,000 $540,000 $540,000 $ 7.20 EBIT Interest EBT Taxes (40%) NI P EAC EPS 16-8B (a) Plan B $900,000 240,000 $660,000 264,000 $396,000 $396,000 $ 7.20 (EBIT  I)(1  t)  P Ss = (EBIT  I)(1  t)  P Sb (EBIT  $0)(1  0.5)  1,200,000 = (EBIT  $315,000)(1  0.5)  850,000 0.5EBIT 120 = 0.5EBIT  $157,500 85 EBIT = $1,080,000 163 (b) Plan A $1,080,000 $1,080,000 540,000 $ 540,000 $ 540,000 $ 0.45 EBIT Interest EBT Taxes (50%) NI P EAC EPS Plan B $1,080,000 315,000 $ 765,000 382,500 $ 382,500 $ 382,500 $ 0.45 (c) Analysis chart follows (d) Since $1,500,000 exceeds $1,080,000, the levered plan (Plan B) will provide for higher EPS $0.65 Plan B Plan A 0.55 $0.45 Indif. level EPS 0.45 0.35 0.25 0.15 $315,000 $0.5 Mil $1,080,000 $1.0 Mil $1.5 Mil EBIT 164 $2.0 Mil 16-9B (a) At EBIT of $1,500,000 the respective EPS amounts are: Plan A = $0.63 Plan B = $0.70 The stock prices then are: Plan A: ($0.63) (13) = $8.19 Plan B: ($0.70) (11) = $7.70 Plan A offers the higher stock price (b) (c) ($0.70) (P/E) = $8.19 P/E = $8.19 = 11.7 times $0.70 The penalized price/earnings ratio resulting from use of financial leverage may well favor the unlevered financing plan when the ultimate effect on the firm's stock price is considered 16-10B (a) FC = Interest + Sinking Fund FC = $600,000 + $300,000 = $900,000 (b) where: and, so, (c) 16-11B (a) (b) (c) CBr = Co + NCFr - FC Co = $750,000 FC = $900,000 NCFr = $3,700,000 - $3,200,000 = $500,000 CBr = $ 750,000 + $500,000 - $900,000 CBr = $350,000 The firm ordinarily carries a $750,000 cash balance This analysis shows that during a tight economic period the firm's cash balance (CB r) could fall to as low as $350,000 Management might well decide not to issue the proposed bonds Firm C appears to be excessively levered Both its debt ratio and burden coverage ratio are unfavorable relative to the industry norm The firm's price/earnings ratio is significantly lower (5 versus 10) than the industry norm Firm B The investing market place seems to place more weight on coverage ratios than balance sheet financial leverage measures Thus, Firm B's price/earnings ratio exceeds that of Firm A 165 16-12B (a) (b) Firm Y seems to be most appropriately levered Its price/earnings ratio exceeds that of both Firms X and Z The first financial leverage effect refers to the added variability in the earnings-per-share stream caused by the firm's use of leverage-inducing financial instruments The second financial leverage effect concerns the level of earnings per share at a specific EBIT associated with a specific capital structure Beyond some critical EBIT level, earnings per share will be higher if more (rather than less) leverage is used Based on the tabular data in this problem, the market seems to be weighing the second leverage effect more heavily Thus, Firm Z seems to be underlevered 16-13B (a) ($22) (1,000,000 shares) = $22,000,000 (b) Kc = Dt E $4.75 = t = = 21.59% Po Po $22 In the all equity firm Kc = Ko, thus, Ko = 21.59% (c) Kc = (1) $4.882 = 22.19% $22.0 EBIT $4,750,000 - Interest 90,000 EAC $4,660,000 ÷ 954,545* = Dt $4.882 *$1,000,000 ÷ $22 = 45,455 shares retired 16-14B (a) (b) (2) $4.882  $4.750 = 0.0278 or 2.78% 4.750 (3) 22.19%  21.59% = 0.0278 or 2.78% 21.59% (4) 954,545 45,455 ( 22.19) + (9.00) = 21.59% 1,000,000 1,000,000 ($38) (575,000 shares) = $21,850,000 Kc = Dt E $7.826 = t = = 20.595% Po Po $38 In the all equity firm Kc = Ko, thus, Ko = 20.595% 166 (c) Kc = (1) $8.095 = 21.3% $38.00 EBIT - Interest EAC ÷ Dt $4,500,000 165,000 $4,335,000 535,526 $8.095 shares* *$1,500,000 ÷ $38 = 39,474 shares retired 16-15B (a) (2) $8.095  $7.826 = 3.437% $7.826 (3) 21.3%  20.595% = 3.423% 20.595% (4) 535,526 39,474 (21.3%) + (11 0%) = 20.59% 575,000 575,000 Plan B will always dominate Plan C, the preferred stock alternative, by 0.5 ($5,000)/10,000 shares or $0.25 a share Thus, only alternatives A versus B and A versus C need be evaluated Those calculations appear below Plan A versus Plan B (EBIT  $0)(1  0.5)  15,000 = (EBIT  $5,000)(1  0.5) 10,000 EBIT = $15,000 Plan A versus Plan C (EBIT  $0)(1  0.5)  15,000 EBIT (b) = = (EBIT  0)(1  0.5)  $5,000 10,000 $30,000 Since long-term EBIT is forecast to be $36,000, the data favor use of financing alternative B, the bond plan This is well above the A versus B indifference level of $15,000 Earnings per share Plan A $1.20 Plan B $1.55 Earnings per share is highest under Plan B 167 Plan B $1.55 ... cycle 16- 17 Financial managers clearly favor the use of internally generated equity in the financing of capital budgets SOLUTIONS TO END-OF -CHAPTER PROBLEMS Solutions to Problem Set A 16- 1A a... END-OF -CHAPTER QUESTIONS 16- 1 (a) Financial structure: the mix of all items that appear on the right-hand side of the company's balance sheet (b) Capital structure: the mix of long-term funds used by. .. alternative 16- 3 The objective of capital structure management is to mix the permanent sources of funds used by the firm in a manner that will maximize the company's common stock price 16- 4 Balance