Financial Management Chapter 16 IM 10th Ed

8/2/2019 Financial Management Chapter 16 IM 10th Ed

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CHAPTER 16

Planning theFirm'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 financialleverage use on the composite cost of capital is adopted. Later, techniques useful to thefinancial officer faced with the determination of an appropriate financing mix are described.

CHAPTER OUTLINE

I. Introduction

A. A distinction between financial structure and capital structure

1. Financial structure is the mix of items on the right-hand side of the

firm's balance sheet.2. Capital structure is the mix of long-term sources of funds.

3. The main focus will be capital structure management and not theappropriate maturity composition of the sources of funds.

B. The objective of capital structure management is to mix the permanentsources of funds in a manner that will maximize the company's commonstock price. This proper mix of fund sources is referred to as the optimalcapital structure.

II. A glance at capital structure theory

A. The cost of capital – capital structure argument may be characterized by thisquestion: Can the firm affect its overall cost of funds by varying the mixtureof financing sources used?

B. If the firm's cost of capital can be affected by the degree to which it usesfinancial leverage, then capital structure management is important.



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C. The analytical discussion revolves around a simplified version of the basicdividend valuation model.

1. It assumes (a) cash dividends paid will not change over the infiniteholding period, and (b) the firm retains none of its current earnings.

2. The analytical setting for the discussion of capital structure theoryassumes (a) corporate income is not subject to any taxation, (b) capitalstructures consist of only stocks and bonds, (c) the expected values of all investors' forecasts of the future levels of net operating income foreach firm are identical, and (d) securities are traded in perfect orefficient financial markets.

III. 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 whichthe firm chooses to use financial leverage.

B. Total market value of the firm's outstanding securities is unaffected by thearrangement of the right-hand side of the balance sheet.

C. The independence hypothesis rests upon what is called the net operatingincome (NOI) approach to valuation.

D. The use of a greater degree of financial leverage may result in greaterearnings and dividends, but the firm's cost of common equity will rise atprecisely the same rate as the earnings and dividends.

IV. 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 financialleverage.

B. Regardless of the firm's use of debt financing, both its cost of debt and equitycapital will not be affected by capital structure adjustments.

C. The cost of debt is less than the cost of common equity, implying greaterfinancial 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.

V. 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.



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B. When interest expense is tax deductible, the sum of the cash flows that thefirm could pay to all contributors of corporate capital is affected by itsfinancing mix. This is not the case when an environment of no corporatetaxation is presumed.

1. 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

2. This position presents the view that the tax shield must have value inthe marketplace.

3. Therefore, financial leverage affects firm value, and it must also affectthe cost of corporate capital.

C. There is some point at which the expected cost of default is large enough tooutweigh the tax shield advantage of debt financing. At that point, the firmwill turn to common equity financing.

D. The determination of the firm's financing mix is centrally important to boththe financial manager and the firm's owners.

VI. Firm Value, Agency Costs, the Static Trade-off Theory, and the Pecking OrderTheory

A. To ensure that agent-managers act in the stockholders' best interest requires

1. Proper incentives to do so through compensation plans and perquisites

2. Decisions that are monitored through bonding, auditing financialstatements, limiting decisions, and reviewing the perquisites

B. Agency problems stem from conflicts of interest between firm managementand owners; capital structure management encompasses a natural conflictbetween stockholders and bondholders.

1. To reduce the conflict of interest, creditors and stockholders mayagree to include several protective covenants in the bond contract.

2. Monitoring costs should differ in direct proportion to low or highlevels of leverage.

C. Static trade-off theory distinguished from pecking order theory

1. Static trade-off theory provides for the identification of a preciseoptimum financing mix. This financing mix should logicallydetermine the firm's targeted leverage ratio.

2. Static trade-off theory "prices" both expected financial distress costsand agency costs.



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3. Pecking order theory suggests that firm's finance projects within awell-defined hierarchy that begins with internally generated funds andends with new common equity (the least desired funds source).

4. Thus, pecking order theory provides no precisely defined targetleverage ratio since typical leverage metrics just reflect the firm's

cumulative external financing needs over time.

VII. Agency costs, free cash flow, and capital structure

A. Free cash flow, as defined by Professor Michael C. Jensen, is the "cash flowin excess of that required to fund all projects that have positive net presentvalues 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 financingmix.

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 determinationof 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.

VIII. Basic tools of capital structure management

A. The use of financial leverage has two effects on the earnings stream flowingto 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 equateEPS regardless of the financing plan chosen

1. A graphic or algebraic analysis can be used.

2. By allowing for sinking fund payments, the analysis can focus uponuncommitted earnings per share.

3. EBIT-EPS analysis considers only the level of the earnings stream andignores the variability in it.

C. Comparative leverage ratios involve the computation of various balance sheetleverage ratios and coverage ratios.

D. The use of industry norms in conjunction with comparative leverage ratioscan aid in arriving at an appropriate financing mix.



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E. Cash flow analysis (company-wide cash flows) is the study of projectedimpact of capital structure decisions on corporate cash flows. According tothis tool, the appropriate level of financial leverage is reached when thechance of running out of cash is exactly equal to that which management willassume. An underlying assumption is that management's risk-bearing

preferences are conditioned by the investing marketplace.

IX. 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 reportedin the firm’s financial statements.

C. Variations in exchange rates impact firm’s overall earnings.

1. This can impact stock price, negatively if foreign currency depreciatedin value against the dollar or positively if the currency appreciated invalue.

2. Firms with high exposure to currency risk may choose to minimizeother financial risk.

X. How financial managers use this material

A. The opinions and practices of financial executives reinforce the major topicscovered in this chapter.

B. Target debt ratios are widely used by financial officers.

C. Executives operationalize debt capacity in different ways. The most popularapproach is to define the firm's debt capacity as a target percent of totalcapitalization.

D. Changes in the aggregate business environment, known as business cycles,affect capital structure decisions. Some phases of the cycle favor debtfinancing over equity financing; in other phases equity financing is preferred.

E. The single most important factor that should affect the firm's financing mix isthe underlying nature of the business in which it operates. A firm's businessrisk must be carefully assessed.

ANSWERS TOEND-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 thecomposite cost of capital for raising a given amount of funds.



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(d) Debt capacity: the maximum proportion of debt that the firm can include inits 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 andvariability of the EPS flowing to the common stockholders. EBIT-EPS analysisdeals 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. EBIT-EPSanalysis 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 tothose supplied by owners. The inputs to these metrics come from the company'sbalance sheet. Coverage ratios relate the earnings or cash flow amounts that areavailable for servicing financing contracts to the associated financing costs. Theinputs to computing coverage ratios generally come from the company's income

statement. At times, footnotes to the financial statements might have to be consultedto complete some coverage ratios. Table 16-7 in the text identifies the calculationmethods for several popular leverage ratios.

16-5. If revenues from sales are highly volatile, then other things being equal, cash flowswill be volatile. This would make it difficult to meet, on a timely basis, a largeamount of fixed financing costs. Because of this, a high degree of financial risk willbe avoided by firms that operate in industries which experience large salesfluctuations.

16-6. If the firm's overall cost of capital is not affected by varying the mixture of financingsources 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'sfinancing mix, then capital structure management is a sterile process.

16-7. Within the realm of capital structure theory, the independence hypothesis offers thatboth common stock price and the composite cost of capital are not affected by thefirm's use of financial leverage. This presumes that interest expense is not taxdeductible.

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 saucer-shaped, or U-shaped, with respect to the use of financial leverage. Over moderatedegrees 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 degreesof 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 regardlessof the financing plan ultimately chosen from a set of two alternatives.

16-11. UEPS is the earnings available to the common shareholders minus sinking fundpayments that have been honored.



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16-12. Industry norms for the various balance sheet leverage ratios and coverage ratios onlyprovide rough guidelines for the design of the firm's financing mix. Norms areusually averages or some other measure of central tendency. Few firms in reality willhave the same operating characteristics as a hypothetical "normal" firm. Thus, normsare 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 shouldbe available.

16-13. Free cash flow is the cash flow in excess of that required to fund all projects thathave 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 leverage-inducinginstruments in the firm's capital structure, then shareholders will enjoy increasedcontrol 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 increasedsubstantially 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 (sayexpansion or contraction) of the cycle.

16-17. Financial managers clearly favor the use of internally generated equity in thefinancing of capital budgets.

SOLUTIONS TO

END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

16-1A.a. FC = Interest + Sinking Fund

FC = ($15 Million) (.18) +years30

million$15

FC = $2,700,000 + $500,000 = $3,200,000

b. CBr = Cb0 + NCFr – FC

Where: CB0 = $2,000,000

FC = $3,200,000

and NCFr = $4,950,000 - $4,000,000 = $950,000

so, CBr = $2,000,000 + $950,000 - $3,200,000

CBr = -$250,000



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c. We see that the company has a preference for a $2 million cash balance. Thecombination of the recessionary period and the proposed issue of bonds would put the firm’s recessionary cash balance (CBr) at -$250,000. The combinationof 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 onsales, 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 = desired cash balance at end of recessionary period = $200,000C0 = cash balance at beginning of period = $200,000OR = other cash receipts (as percent of sales receipts) = 5%Pa = payroll expenditures (as percent of sales receipts) = 30%RM = raw material payments (as percent of sales receipts) = 25%En = total nondiscretionary expenditures = $500,000FC = fixed financial charges = $140,000

thus

CS = {CBr - C0 + En + FC} / {1 - (-OR% + Pa% + RM%)}

CS = %)25%30%5(1

000,140$000,500$000,200$000,200$

= $1,280,000

PROOF:


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



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16-3A. At the EBIT indifference level:

EPS (All Debt Plan) = EPS (Debt and Equity Plan)

that is,

AllDebtS

SF]Pt)I)(1[(EBIT

=DebtEquityS

SF]Pt)I)(1[(EBIT

100,000

$50,000].35)$90,000)(1[(EBIT =

30,000)(100,000

$20,000].35)$32,000)(1[(EBIT

10

$108,500.65EBIT=

13

$40,800.65EBIT

EBIT = $514,103

16-4A.

(a)sS

Pt)I)(1(EBIT

=bS

Pt)I)(1(EBIT

1,000,000

00.5)$0)(1(EBIT =

700,000

00.5)1$600,000)((EBIT

10

0.5EBIT=

7

$300,0000.5EBIT

EBIT = $2,000,000

(b) Plan A Plan BEBIT $2,000,000 $2,000,000Interest 0 600,000EBT $2,000,000 $1,400,000Taxes 1,000,000 700,000NI $1,000,000 $ 700,000P 0 0EAC $1,000,000 $ 700,000EPS $ 1.00 $ 1.00

(c) See following analysis chart.



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(d) Since $2,400,000 exceeds $2,000,000, the levered plan (Plan B) will providefor higher EPS.

$2

1.5

1.0

0.5

0 $ 1 M i l . $ 2 M i l . $ 3 M i l . $ 4 M i l .

Plan B Plan A

$1.0 Indif. level

$600,000

16-5A.

(a) ($30) (900,000 shares) = $27,000,000

(b) Kc =o

t

P

D=

o

t

P

E=

30$

6$= 20%

In the all equity firm Kc = Ko, Thus, Ko = 20%

(c) Kc =0.30$

21.6$= 20.7%

(1) EBIT $5,400,000- Interest 120,000EAC $5,280,000÷ 850,000 shares* = Dt $6.21

*$1,500,000 ÷ $30 = 50,000 shares retired.



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(2)00.6$

00.6$21.6$ = 0.035 or 3.5%

(3)%0.20

%0.20%7.20 = 0.035 or 3.5%

(4) %)7.20(275.25 + %)0.8(

275.1 = 20.0%

16-6A.

(a)shares80,000

0.4)0)(1(EBIT =

shares40,000

0.4)1$120,000)((EBIT

80

0.6EBIT=

40

$72,0000.6EBIT

EBIT = $240,000

(b) Plan A Plan BEBIT $240,000 $240,000Interest 0 120,000EBT $240,000 $120,000Taxes (40%) 96,000 48,000EAC $144,000 $72,000÷ No. of common shares 80,000 40,000EPS $1.80 $1.80

16-7A.

(a)shares100,000

0.34)0)(1(EBIT =

shares50,0000.34)1$110,000)((EBIT

10

0.66EBIT=

5

$72,6000.66EBIT

EBIT = $220,000

(b) Since $300,000 exceeds the indifference level of $220,000 from part (a), thelevered alternative (Plan B) will generate the higher EPS.



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(c) Here we compute EPS for each financing plan, apply the relevantprice/earnings ratios, and, thereby, forecast a common stock price for eachplan. Thus, we have:

Plan A Plan B

EBIT $300,000 $300,000Interest 0 110,000EBT $300,000 $190,000Taxes (34%) 102,000 64,600NI $198,000 $125,400P 0 0EAC $198,000 $125,400÷ No. of common shares 100,000 50,000EPS $1.98 $2.508x P-E ratio 19 15= Projected Stock Price $37.62 $37.62

The added riskiness of Plan B, owing to the use of financial leverage, isreflected in the lower P-E ratio associated with Plan B (i.e., 15x versus 19xfor Plan A). The rational investor will prefer Plan A (unlevered) as the sameprojected stock price ($37.62) can be obtained with a lower level of risk exposure.

16-8A.(a)

shares75,000

0.34)0)(1(EBIT =

shares50,000

0.34)1$150,000)((EBIT

75

.66EBIT=

50

$99,000.66EBIT

EBIT = $450,000

(b) Plan A Plan BEBIT $450,000 $450,000Interest 0 150,000EBT $450,000 $300,000Taxes (34%) 153,000 102,000EAC $297,000 $198,000

÷ No. of common shares 75,000 50,000EPS $3.96 $3.96



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16-9A.

(a)shares100,000

0.5)$0)(1(EBIT =

shares50,000

0.5)1$320,000)((EBIT

10

0.5EBIT=

5

$160,0000.5EBIT

EBIT = $640,000

(b) Plan A Plan BEBIT $640,000 $640,000Interest 0 320,000EBT $640,000 $320,000Taxes (50%) 320,000 160,000NI $320,000 $160,000P 0 0EAC $320,000 $160,000÷ No. of Common Shares 100,000 50,000

EPS $ 3.20 $ 3.20

(c) Since $800,000 exceeds the calculated indifference level of $640,000, thelevered plan (Plan B) will generate the higher EPS.

(d) To solve this part of problem 10-6A, compute EPS under each financialalternative. Then apply the relevant price-earnings ratio for each plan. Anassociated common stock price for each plan can then be forecast. Thisfollows.

Plan A Plan B

EBIT $800,000 $800,000Interest 0 320,000EBT $800,000 $480,000Taxes (50%) 400,000 240,000NI $400,000 $240,000P 0 0EAC $400,000 $240,000÷ No. of Common Shares 100,000 50,000EPS $ 4.00 $ 4.80X P-E Ratio 12 10= Projected Stock Price $48.00 $48.00

The riskiness is reflected in a lower P-E ratio for Plan B of 10 versus that of 12 for Plan A (the all common equity plan). The decision now can logicallyshift to Plan A (unlevered). The investors obtain the same stock price of $48.00 under both plans. The risk of Plan A is lower, so it would bepreferable.



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16-10A.(a) FC = Interest + Sinking Fund

FC = ($10 million) (.15) +20yr.

n)($10millio

FC = $1,500,000 + $500,000 = $2,000,000

(b) CBr = CB0 + NCFr - FC

where:

CB0 = $1,000,000

FC = $2,000,000

and,

NCFr = $4,300,000 - $3,400,000 = $900,000

so,

CBr = $1,000,000 + $900,000 - $2,000,000

CBr = - $100,000

(c) We see that the company has a preference for a $1 million cash balance. Thecombination of the recessionary period and the proposed issue of bondswould put the firm's recessionary cash balance (CBr ) at -$100,000. Thecombination of this negative number and the statement that the firm likes acash balance of $1 million suggests strongly that the proposed bond issue bepostponed.

16-11A.

(a)60,000

0.4)$0)(1(EBIT

=40,000

0.4)1$100,000)((EBIT

6

0.6EBIT=

4

$60,0000.6EBIT

EBIT = $300,000

(b) Plan A Plan BEBIT $300,000 $300,000Interest 0 100,000EBT $300,000 $200,000Taxes (40%) 120,000 80,000

NI $180,000 $120,000P 0 0EAC $180,000 $120,000EPS $ 3.00 $ 3.00



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16-12A.

(a)sS

Pt)I)(1(EBIT

=bS

Pt)I)(1(EBIT

1,400,000

00.5)$0)(1(EBIT

= 1,000,000

00.5)1$320,000)((EBIT

14

0.5EBIT=

10

$160,0000.5EBIT

EBIT = $1,120,000

(b) Plan A Plan BEBIT $1,120,000 $1,120,000Interest 0 320,000EBT $1,120,000 $ 800,000Taxes 560,000 400,000NI $ 560,000 $ 400,000P 0 0EAC $ 560,000 $ 400,000EPS $ 0.40 $ 0.40

(c) Analysis chart is on the following page.

(d) Since $1,800,000 exceeds $1,120,000, the levered plan (Plan B) will providefor higher EPS.

16-13A.

(a) At EBIT of $1,800,000 the respective EPS amounts are:

Plan A = $0.64 (rounded from $0.6429)

Plan B = $0.74

The stock prices then are:

Plan A: ($0.64) (12) = $7.68

Plan B: ($0.74) (10) = $7.40

So Plan A offers the higher stock price.

(b) ($0.74) (PE) = $7.68

PE =$7.68$0.74 = 10.378 times

(c) The penalized price/earnings ratio resulting from use of financial leveragemay well favor the unlevered financing plan when the ultimate effect on thefirm's stock price is considered.



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$0..5 Mi l . $1.0 Mil . $1.5 Mil . $2.0 Mil .

0.10

0.20

0.30

0.40

0.50

$0.60

$0.40 Indif. level

Plan APlan B

$1,120,000$320,000

E P S

EBIT

0

16-14A.

(a) FC = Interest + Sinking Fund

FC = $400,000 + $250,000 = $650,000

(b) CBr = CBo + NCFr - FC

where:

CBo = $500,000

FC = $650,000

and,

NCFr = $3,200,000 - $2,900,000 = $300,000

so,



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CBr = $ 500,000 + $300,000 - $650,000

CBr = $150,000

(c) The firm ordinarily carries a $500,000 cash balance. This analysis shows thatduring a tight economic period the firm's cash balance (CBr) could fall to as

low as $150,000. Management might well decide not to issue the proposedbonds.

16-15A.(a) Firm C appears to be excessively levered. Both its debt ratio and burden

coverage ratio are unfavorable relative to the industry norm. The firm'sprice/earnings ratio is significantly lower (6 versus 10) than the industry norm.

(b) Firm B.(c) The investing market place seems to place more weight on coverage ratios

than balance sheet leverage measures. Thus, Firm B's price/earnings ratioexceeds that of Firm A.

16-16A.(a) Firm Y seems to be most appropriately levered. Its price/earnings ratio

exceeds that of both Firms X and Z.(b) The first financial leverage effect refers to the added variability in the

earnings-per-share stream caused by the firm's use of leverage-inducingfinancial instruments. The second financial leverage effect concerns the levelof earnings per share at a specific EBIT associated with a specific capitalstructure. Beyond some critical EBIT level, earnings per share will be higherif more (rather than less) leverage is used. Based on the tabular data in thisproblem the market seems to be weighing the second leverage effect moreheavily. Thus, Firm Z seems to be underlevered.

16-17A.

(a) ($20) (1,000,000 shares) = $20,000,000

(b) Kc =o

t

P

D=

o

t

P

E=

20$

5$= 25%

In the all equity firm Kc = Ko, thus, Ko = 25%

(c) Kc =0.20$

179.5$= 25.895%

(1) EBIT $5,000,000- Interest 80,000

EAC $4,920,000÷ 950,000= Dt $5.179

(2)000.5

000.5$179.5$ = 0.0358 or 3.58%



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(3)%000.25

%000.25%895.25 = 0.0358 or 3.58%

(4) )895.25(20

19+ )00.8(

20

1= 25.0%



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16-18A.

(a) ($40) (600,000 shares) = $24,000,000

(b) Kc =o

t

P

D=

o

t

P

E=

40$

7$= 17.5%

In the all equity firm Kc = Ko, thus, Ko = 17.5%

(c) Kc =000.40$

13.7$= 17.825%

(1) EBIT $4,200,000- Interest 100,000EAC $4,100,000÷ 575,000 shares* = Dt $7.13

*$1,000,000 ÷ $40 = 25,000 shares retired

(2)00.7$

00.7$13.7$ = 1.86%

(3)%500.17

%500.17%825.17 = 1.86%

(4) %)825.17(24

23+ %)00.10(

24

1= 17.5%

16-19A.

(a) 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 Band A versus C need be evaluated. Those calculations appear below.

Plan A versus Plan B

10,000

00.5)$0)(1(EBIT =

8,000

0.5)$1,800)(1(EBIT

EBIT = $9,000

Plan A versus Plan C

10,00000.5)$0)(1(EBIT

=8,000

$1,8000.5)0)(1(EBIT

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 Bindifference level of $9,000.



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SOLUTION TO INTEGRATIVE PROBLEM

PART I EBIT-EPS ANALYSIS

1. At the EBIT indifference level:

EPS (LLP) = EPS (HLP)

LLPS

P]t)I)(1[(EBIT

=HLPS

P]t)I)(1[(EBIT

400,000

0].35)1$220,000)([(EBIT =

200,000

0].35)1$840,000)([(EBIT

40

$143,000.65EBIT= 20

$546,000.65EBIT

EBIT = $1,460,000

See graph on following page.

2. The analytical income statement demonstrating that EPS (LLP) = EPS (HLP) is asfollows:

LLP HLP

EBIT $1,460,000 $1,460,000Interest 220,000 840,000EBT $1,240,000 $620,000Taxes (35%) 434,000 217,000NI $806,000 $403,000P 0 0EAC $806,000 $403,000÷ # of common shares 400,000 200,000EPS $2.015 $2.015

3. The expected long-term EBIT of $1,300,000 does not exceed the EBIT indifferencelevel. Consequently, the low leveraged plan, LLP, will produce the higher EPS.

4. To determine the financing plan that should be recommended, it is necessary tocompute the expected stock price under each plan. To do so, EPS is computed first,then the projected stock price is computed, as follows:





$4.000

$3.500

$3.000

$2.500

$2.000

$1.500

$1.000

$0.500

$0.000

$0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 $2,000,000

411

EBIT-EPS INDIFFERENCE CHART

E P S i n D O L L A R S

$2.015

EBIT Indifference Level

$1,460,000

HLP

LLP

EBIT in Dollars



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Prof. Rushen Chahal

415

LLP HLPEBIT $1,300,000 $1,300,000Interest 220,000 840,000EBT $1,080,000 $460,000

Taxes (35%) 378,000 161,000NI $702,000 $299,000P 0 0EAC $702,000 $299,000÷ Number of common shares 400,000 200,000EPS $1.755 $1.495x P/E ratio 18 14= Projected stock price $31.590 $20.930

The preferred plan is the one with the higher projected stock price, namely LLP. It alsocan be noted that the greater riskiness of HLP results in the market applying a lowerprice/earnings multiple to the expected EPS.

5. To find the P/E ratio that equates the stock prices for both plans at the given EBITlevel, it is only necessary to solve the formula, EARNINGS x P/E RATIO = PRICE,as follows:

Price [under LLP] $31.59÷ Earnings [under HLP] 1.495= P/E Ratio 21.130

PART 2 RECESSIONARY CASH FLOW ANALYSIS

6. Total fixed financial charges, FC, the firm would have to pay next year are computedusing the following formula:

FC = interest expense + sinking fund/year

where

LLP HLP

Proposed dollar amount of new bonds $2,000,000 $6,000,000x Interest rate x 11% x 14%= Interest expense $220,000 $840,000

Proposed dollar amount of new bonds $2,000,000 $6,000,000x Sinking fund requirement/year x 10% x 10%= Sinking fund/year $200,000 $600,000

thus,FC = $420,000 $1,440,000



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416

7. 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

LLP HLPC0 = Cash balance at beginning of period = $500,000 $500,000

CS = Cash collections from sales = $4,000,000 $4,000,000

OR = Miscellaneous cash receipts = $200,000 $200,000Pa = Payroll expenditures = $1,500,000 $1,500,000

RM = Raw material payments = $1,000,000 $1,000,000Te = Estimated tax payments = $265,000 $54,000

En = All other nondiscretionary cash outlays = $700,000 $700,000

FC (as computed) = $420,000 $1,440,000

thus, CBr = $815,000 $6,000

8. The firm prefers to maintain a cash balance of $500,000. Yet, the combined effect of arecession and the costs associated with the proposed new debt would result inrecessionary cash balances of $815,000 and $6,000 for LLP and HLP, respectively.Consequently, the lower leverage plan, LLP, is recommended over the higher leverageplan, 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:


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 + E

n+ FC



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417

where

CBr = desired cash balance at end of recessionary period = $400,000

C0 = cash balance at beginning of period = $400,000

OR = other cash receipts (as percent of sales receipts) = 5%

Pa = payroll expenditures (as percent of sales receipts) = 40%RM = raw material payments (as percent of sales receipts) = 20%En = total nondiscretionary expenditures = $500,000

FC = fixed financial charges = $300,000

thus

CS = {CBr - C0 + En + FC} / {1 - (-OR% + Pa% + RM%)}

CS =

%)20%40%5(1

000,300$000,5000$000,400$000,40$

= $1,777,778

PROOF:


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)

that is,

AllDebtS

SF]Pt)I)(1[(EBIT

=Equity&DebtS

SF]Pt)I)(1[(EBIT

100,000

$100,000].35)1$200,000)([(EBIT =

70,000)(100,000

$30,000].35)$48,000)(1[(EBIT

10

$230,000.65EBIT=

17

$61,200.65EBIT

EBIT = $724,835



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16-3B. (a)shares150,000

0.34)0)(1(EBIT =

shares50,000

0.34)1$220,000)((EBIT

15

0.66EBIT=

5

$145,2000.66EBIT

EBIT = $330,000

(b) Since $450,000 exceeds the indifference level of $330,000 from part (a), thelevered alternative (Plan B) will generate the higher EPS.

(c) Here we compute EPS for each financing plan, apply the relevant price/earningsratios, and, thereby, forecast a common stock price for each plan. Thus, wehave:

Plan A Plan BEBIT $450,000 $450,000Interest 0 220,000EBT $450,000 $230,000Taxes (34%) 153,000 78,200NI $297,000 $151,800P _______0 _______0EAC $297,000 $151,800÷ No. of common shares 150,000 50,000EPS $ 1.98 $ 3.036x P-E ratio 19 12.39= Projected Stock Price $37.62 $37.62

The added riskiness of Plan B, owing to the use of financial leverage, isreflected 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 sameprojected stock price ($37.62) can be obtained with a lower level of risk exposure.

16-4B. (a)shares80,000

0.34)0)(1(EBIT =

shares50,000

0.34)1$320,000)((EBIT

80

.66EBIT=

50

$211,200.66EBIT

EBIT = $853,333

(b) Plan A Plan BEBIT $853,333 $853,333Interest 0 320,000EBT $853,333 $533,333Taxes (34%) 290,133 181,333EAC $563,200 $352,000÷ No. of common shares 80,000 50,000EPS $7.04 $7.04



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419

16-5B.

(a)shares75,000

0.5)$0)(1(EBIT =

shares50,000

0.5)1$140,000)((EBIT

75

0.5EBIT=

50

$70,0000.5EBIT

EBIT = $420,000

(b) Plan A Plan BEBIT $420,000 $420,000Interest 0 140,000EBT $420,000 $280,000Taxes (50%) 210,000 140,000NI $210,000 $140,000P 0 0EAC $210,000 $140,000÷ No. of Common Shares 75,000 50,000EPS $ 2.80 $ 2.80

(c) Since $750,000 exceeds the calculated indifference level of $420,000, thelevered plan (Plan B) will generate the higher EPS.

(d) To solve this part of the problem, compute EPS under each financialalternative. Then apply the relevant price-earnings ratio for each plan. Anassociated common stock price for each plan can then be forecast. Thisfollows.

Plan A Plan BEBIT $750,000 $750,000Interest 0 140,000EBT $750,000 $610,000Taxes (50%) 375,000 305,000NI $375,000 $305,000P 0 0EAC $375,000 $305,000÷ No. of Common Shares 75,000 50,000EPS $ 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 forPlan A (the all common equity plan). The decision now can logically shift to PlanA (unlevered). The investors obtain the same stock price of $60.00 under bothplans. There is less risk in Plan A, so it would be preferable.



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420

16-6B. (a) FC = Interest + Sinking Fund

FC = ($11 million) (.16) +20yr.

n)($11millio

FC = $1,760,000 + $550,000 = $2,310,000

(b) CBr = CB0 + NCFr - FCwhere: 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

(c) We see that the company has a preference for a $500,000 cash balance. Thecombination of the recessionary period and the proposed issue of bonds would

put the firm's recessionary cash balance (CBr) at -$1,610,000. Thecombination of this negative number and the statement that the firm likes acash balance of $500,000 suggests strongly that the proposed bond issue bepostponed.

16-7B.(a)75,000

0.4)$0)(1(EBIT =

55,000

0.4)1$240,000)((EBIT

75

0.6EBIT=

55

$144,0000.6EBIT

EBIT = $900,000

(b) Plan A Plan BEBIT $900,000 $900,000Interest 0 240,000EBT $900,000 $660,000Taxes (40%) 360,000 264,000NI $540,000 $396,000P 0 0EAC $540,000 $396,000EPS $ 7.20 $ 7.20

16-8B. (a)sS

Pt)I)(1(EBIT

=bS

Pt)I)(1(EBIT

1,200,000

00.5)$0)(1(EBIT =

850,000

00.5)1$315,000)((EBIT

120

0.5EBIT=

85

$157,5000.5EBIT

EBIT = $1,080,000



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421

(b) Plan A Plan BEBIT $1,080,000 $1,080,000Interest 0 315,000EBT $1,080,000 $ 765,000Taxes (50%) 540,000 382,500

NI $ 540,000 $ 382,500P 0 0EAC $ 540,000 $ 382,500EPS $ 0.45 $ 0.45

(c) Analysis chart follows.

(d) Since $1,500,000 exceeds $1,080,000, the levered plan (Plan B) will provide forhigher EPS.

$0.5 Mil. $1.0 Mil. $1.5 Mil. $2 .0 Mil.

0.15

0.25

0.35

0.45

0.55

$0.65

$0.45 Indif. level

Plan APlan B

$1,080,000$315,000

E P S

EBIT

0



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422

16-9B.(a) At EBIT of $1,500,000 the respective EPS amounts are:

Plan A = $0.63Plan B = $0.70

The stock prices then are:

Plan A: ($0.63) (13) = $8.19Plan B: ($0.70) (11) = $7.70

Plan A offers the higher stock price.

(b) ($0.70) (P/E) = $8.19

P/E =70.0$

19.8$= 11.7 times

(c) 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'sstock price is considered.

16-10B.

(a) FC = Interest + Sinking Fund

FC = $600,000 + $300,000 = $900,000

(b) CBr = Co + NCFr - FC

where: Co = $750,000

FC = $900,000

and, NCFr = $3,700,000 - $3,200,000 = $500,000

so, CBr = $ 750,000 + $500,000 - $900,000

CBr = $350,000

(c) The firm ordinarily carries a $750,000 cash balance. This analysis shows thatduring a tight economic period the firm's cash balance (CBr) could fall to as low

as $350,000. Management might well decide not to issue the proposed bonds.16-11B.

(a) Firm C appears to be excessively levered. Both its debt ratio and burden

coverage ratio are unfavorable relative to the industry norm. The firm'sprice/earnings ratio is significantly lower (5 versus 10) than the industry norm.

(b) Firm B.(c) The investing market place seems to place more weight on coverage ratios than

balance sheet financial leverage measures. Thus, Firm B's price/earnings ratioexceeds that of Firm A.



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16-12B.(a) Firm Y seems to be most appropriately levered. Its price/earnings ratio exceeds

that of both Firms X and Z.(b) 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 earningsper share at a specific EBIT associated with a specific capital structure. Beyondsome critical EBIT level, earnings per share will be higher if more (rather thanless) leverage is used. Based on the tabular data in this problem, the marketseems to be weighing the second leverage effect more heavily. Thus, Firm Zseems to be underlevered.

16-13B.

(a) ($22) (1,000,000 shares) = $22,000,000

(b) Kc =o

t

P

D=

o

t

P

E=

22$

75.4$= 21.59%


(c) Kc =0.22$

882.4$= 22.19%

(1) EBIT $4,750,000- Interest 90,000EAC $4,660,000÷ 954,545* = Dt $4.882

*$1,000,000 ÷ $22 = 45,455 shares retired

(2)750.4

750.4$882.4$ = 0.0278 or 2.78%

(3)%59.21

%59.21%19.22 = 0.0278 or 2.78%

(4) )19.22(000,000,1

545,954+ )00.9(

000,000,1

455,45= 21.59%

16-14B.(a) ($38) (575,000 shares) = $21,850,000

(b) Kc =o

t

P

D=

o

t

P

E=

38$

826.7$= 20.595%




Prof. Rushen Chahal

(c) Kc =00.38$

095.8$= 21.3%

(1) EBIT $4,500,000- Interest 165,000

EAC $4,335,000÷ 535,526 shares* Dt $8.095

*$1,500,000 ÷ $38 = 39,474 shares retired

(2)826.7$

826.7$095.8$ = 3.437%

(3)%595.20

%595.20%3.21 = 3.423%

(4) %)3.21(000,575526,535 + %)0.11(

000,575474,39 = 20.59%

16-15B.(a) 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 andA versus C need be evaluated. Those calculations appear below.

Plan A versus Plan B

15,000

00.5)$0)(1(EBIT =

10,000

0.5)$5,000)(1(EBIT

EBIT = $15,000

Plan A versus Plan C

15,000

00.5)$0)(1(EBIT =

10,000

$5,0000.5)0)(1(EBIT

EBIT = $30,000

(b) Since long-term EBIT is forecast to be $36,000, the data favor use of financingalternative B, the bond plan. This is well above the A versus B indifference

level of $15,000.

Earnings per share$1.20

APlan

$1.55

BPlan

$1.55

BPlan

Earnings per share is highest under Plan B.

Documents

Financial Management Chapter 16 IM 10th Ed