MANAGEMENTCONSULTANCY - Solutions Manual CHAPTER18 LONG-TERM FINANCING DECISIONS I Questions Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy Debt can only be used up to a point Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature Operating leverage primarily affects the operating income of the firm At this point, financial leverage takes over and determines the overall impact on earnings per share At progressively higher levels of operation than the break-even point, the percentage change in operating income as a result of a percentage change in unit volume diminishes The reason is primarily mathematical as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less The point of equality only measures indifference based on earnings per share Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt From a purely economic viewpoint, a firm should not ration capital The firm should be able to find additional funds and increase its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost II Multiple Choice D C 18-1 Chapter18 D B A A Long-term Financing Decisions B B III Problems PROBLEM (UNION BUSINESS FORMS) Cost (after-tax) 7.05 10.0 Debt (Kd) Preference shares (Kp) Ordinary equity (Ke) retained earnings 13.0 Weighted average cost of capital (Ka) Weights 35% 15 50 Weighted Cost 2.45% 1.50 6.50 10.45% PROBLEM (HOLLY CORP.) Weighted average cost of capital Debt = 6.60% x 30% = Preference Shares = 9.11% x 10% Ordinary Shares = 11.0% x 60% WACC 1.98% = 0.90% = 6.60% 9.48% PROBLEM (UNION BRICK) The optimal capital budget is P230,000 (Projects A, B, and C) All the projects’ IRR exceeded the average marginal cost PROBLEM (PIZZA EXPRESS) ksp = 10% + 1.38 (5%) = 16.9% kap = 0.5 (12.0%) (0.6) + 0.5 (16.9%) = 12.05% 18-2 Long-term Financing Decisions Chapter18 But kp = IRR = 13.0% Accept the project, its required rate of return is 12.05% PROBLEM (HAPPY GILMORE CO.) Debt = 12.4% (1 = 8.06% x 35% = 2.82% Q -(P35%) - VC) Q (P - VC) - FC - I Preference Shares = x 10% = 0.98% 10,000 (P50 - P20) 10,000 (P50 - P20) - P150,000 - P60,000 Ordinary Shares = + 12% x 55% = 9.35% Weighted average cost of capital 13.15% P4.75 P50 - P1.40 PROBLEM (SNOWBELL COMPANY) Q = 10,000, P = P50,P2.70 VC = P20, FC = P150,000, I = P60,000 P54 Q (P - VC) a DOL = Q (P - VC) - FC = 10,000 (P50 - P20) 10,000 (P50 - P20) - P150,000 = 10,000 (P30) 10,000 (P30) - P150,000 = b DFL c DCL 300,000 P300,000 - P150,000 = EBIT EBIT - I = = P150,000 P90,000 = = 300,000 P150,000 P150,000 P150,000 - P60,000 1.67X = 18-3 = 2.00X Chapter18 Long-term Financing Decisions = = d BE = = = = = 3.33X 5,000 skates PROBLEM (PILAK COMPANY) a INCOME STATEMENTS 10,000 (P30) Return on assets = 10% 10,000 (P30) - P210,000 Current P150,000 EBIT P1,200,000 P50 - P20 Less: Interest 600,000 EBT 600,000 Less: Taxes (45%) 270,000 EAT 330,000 Ordinary shares 750,000 EPS P0.44 P300,000 EBIT = P1,200,000 P90,000 Plan D P150,000 P1,200,000 P30 960,000 240,000 108,000 132,000 375,000 P0.35 Plan E P1,200,000 300,000 900,000 405,000 495,000 1,125,000 P0.44 P6,000,000 debt @ 10% P600,000 interest + (P3,000,000 debt @ 12%) (P6,000,000 - P3,000,000 debt retired) x 10% (P6,000,000 ordinary equity) / (P8 par value) = 750,000 shares Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is equal to the operating return on assets of 10 percent With Plan D, the cost of increased debt rises to 12 percent, and the firm incurs negative leverage reducing EPS and also increasing the financial risk to Pilak b Return on assets EBIT Less: Interest EBT Less: Taxes (45%) EAT Ordinary shares = 5% EBIT = Current P600,000 600,000 0 750,000 Plan D P 600,000 960,000 (360,000) (162,000) P(198,000) 375,000 18-4 P600,000 Plan E P600,000 300,000 300,000 135,000 P165,000 1,125,000 Long-term Financing Decisions EPS P(0.53) Return on assets = 15% EBIT Less: Interest EBT Less: Taxes (45%) EAT Ordinary shares EPS P0.15 EBIT = Current P1,800,000 600,000 1,200,000 540,000 P 660,000 750,000 P0.88 Plan D P1,200,000 960,000 840,000 378,000 P 462,000 375,000 P1.23 Chapter18 P1,800,000 Plan E P1,800,000 300,000 1,500,000 675,000 P 825,000 1,125,000 P0.73 If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides the best EPS Plan D is still risky, having an interest coverage ratio of less than 2.0 c Return on assets EBIT EAT Ordinary shares EPS 750,000 = 750,000 750,000 + = 750,000 = 10% EBIT = Current P1,200,000 P 330,000 750,000 P0.44 Plan D P1,200,000 P 132,000 500,000 P0.26 P1,200,000 Plan E P1,200,000 P 495,000 1,00,000 P0.50 (P3,000,000 / P12 per share) - 250,000 = 500,000 (P3,000,000 / P12 per share) + 250,000 = 1,000,000 As the price of the ordinary shares increases, Plan E becomes more attractive because fewer shares can be retired under Plan D and, by the same logic, fewer shares need to be sold under Plan E 18-5 ... Debt = 12.4% (1 = 8.06% x 35% = 2.82% Q -( P35%) - VC) Q (P - VC) - FC - I Preference Shares = x 10% = 0.98% 10,000 (P50 - P20) 10,000 (P50 - P20) - P150,000 - P60,000 Ordinary Shares = + 12% x 55%... 10,000 (P30) - P150,000 = b DFL c DCL 300,000 P300,000 - P150,000 = EBIT EBIT - I = = P150,000 P90,000 = = 300,000 P150,000 P150,000 P150,000 - P60,000 1.67X = 1 8- 3 = 2.00X Chapter 18 Long-term Financing... P4.75 P50 - P1.40 PROBLEM (SNOWBELL COMPANY) Q = 10,000, P = P50,P2.70 VC = P20, FC = P150,000, I = P60,000 P54 Q (P - VC) a DOL = Q (P - VC) - FC = 10,000 (P50 - P20) 10,000 (P50 - P20) - P150,000