Capital Structure

Q1.1 Lambdoid Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II).Under Plan I, Lambdoid would have 200,000 shares of stock outstanding.Under Plan II, there would be 100,000 shares of stock outstanding and $4 million in debt outstanding.The interest rate on the debt is 10% and there are no taxes.

a.If EBIT is $500,000, which plan will result in higher EPS?

b.If EBIT is $3.5 million, which plan will result in higher EPS?

c.What is the break-even EBIT?

Q1.2 The Lancet Co. is comparing two different capital structures.Plan I would result in 800 shares of stock and $14,000 in debt.Plan II would result in 900 shares of stock and $7000 in debt.The interest rate on the debt is 11%.

a.Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $5000.The all-equity plan would result in 1000 shares outstanding. Which of the three plans has the highest EPS?The lowest?

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 38%.Are the break-even levels of EBIT different from before?Why or why not?

Q1.3 A small retailer is considering the advantages of adding debt to the business capital structure.Currently, $400,000 of assets have been financed entirely with 20,000 shares of common stock.The retailer is considering repurchase of 50% of the equity using proceeds from a bond issue that will require payment of 10% coupon interest.EBIT is projected to be $88,000 for next year, and the applicable corporate income tax rate is 40%.

d.Calculate earnings per share under the current all-equity financing and under the bond issue alternative.

e.Calculate EPS given an 80% repurchase.Should the retailer be encouraged to take on a higher debt-equity ratio?

Q1.4American Presidential is currently financing its $250,000 million in assets with 10 million shares of common stock.American is thinking of replacing its all-equity capital structure with a new capital structure containing 10% preferred stock, 40% debt, and 50% equity.The preferred stock bears a 6% dividend rate and debt pays a coupon of 9%.Projected EBIT is $40 million and the corporate tax rate is 34%.

f.Calculate earnings per share under the current all-equity capital structure and under the alternative financing plan.

g.At what EBIT will American be indifferent between the two capital structure alternatives?

Balance Sheet 12/31/xx Assets Current Assets Fixed Assets 100,000 100,000 Total 200,000 Liabilities Debt Common Equity (10,000 shares) 0 200,000 200,000 Income Statement 12/31/xx Sales Fixed Operating Costs Variable Operating Costs (60%) EBIT Interest EBT Tax (40%) Net Income 200,000 40,000 120,000 40,000 0 40,000 16,000 24,000 EPS = 24,000/10,000 = 2.40 DPS = 24,000/10,000 = 2.40 (dividend payout ratio = 100%) Book value per share = 200,000/10,000 = 20 Market price = 20 Borrowing Schedule: Amount $20,000 40,000 60,000 80,000 100,000 120,000 Debt/Asset Ratio 10% 20% 30% 40% 50% 60% Sales Forecast: Level 100,000 200,000 300,000 Probability .2 .6 .2 kd 8.0% 8.3% 9.0% 10.0% 12.0% 15.0% EBIT - EPS Analysis Debt/Assets = 0% Prob. .2 100,000 40,000 60,000 0 Sales Fixed Costs Variable Costs EBIT Interest EBT Tax (40%) Net Income EPS (10,000) E(EPS) = 2.40 SD(EPS) = 1.52 CV = .63 0 0 0 .6 200,000 40,000 120,000 40,000 0 40,000 16,000 24,000 .2 300,000 40,000 180,000 80,000 0 80,000 32,000 48,000 0 2.40 4.80 0 Debt/Assets = 50% Prob. Sales Fixed Costs Variable Costs EBIT Interest EBT Tax (40%) Net Income .2 100,000 40,000 60,000 0 .6 .2 200,000 300,000 40,000 40,000 120,000 180,000 40,000 80,000 12,000 12,000 12,000 (12,000) 28,000 68,000 (4800) 11,200 27,200 (7200) 16,800 40,800 EPS (5,000) E(EPS) = 3.36 SD(EPS) = 3.04 CV = .90 Debt/Asset 0% 10% 20% 30% 40% 50% 60% (1.44) E(EPS) 2.40 2.56 2.75 2.97 3.20 3.36 3.30 SD(EPS) 1.52 1.69 1.90 2.17 2.53 3.04 3.79 3.36 CV .63 .66 .69 .73 .79 .90 1.15 8.16 D/A Kd E(EPS) Kc=6%+(10%-6%) Po=D/(k-g) (given) (given) (given) (given) 0% 0% 2.40 1.5 12.0% 20.00 10% 8% 2.56 1.55 12.2% 20.98 20% 8.30% 2.75 1.65 12.6% 21.83 30% 9% 2.97 1.8 13.2% 22.50 40% 10% 3.20 2 14.0% 22.86 50% 12% 3.36 2.3 15.2% 22.11 60% 15% 3.30 2.7 16.8% 19.64 Krf Km EPS=DPS g t 6% 10% (given) 0 40% Kwacc 12.00% 11.46% 11.08% 10.86% 10.80% 11.20% 12.12% Debt/Asset 0% 10% 20% 30% 40% 50% 60% E(EPS) 2.40 2.56 2.75 2.97 3.20 3.36 3.30 CV Business Risk 0.63 0.63 0.66 0.63 0.69 0.63 0.73 0.63 0.79 0.63 0.9 0.63 1.15 0.63 Relationship of EPS to Debt R 4.00 3.50 3.00 2.50 EPS 2.00 1.50 1.00 0.50 0.00 0% 10% 20% 30% 40% 50% Debt Ratio Risk to Debt Ratio 1.4 1.2 1 0.8 CV 0.6 0.4 0.2 0 0% 10% 20% 30% 40% 50% Debt Ratio Sales EPS 0% EPS 50% 100,000 0.00 -1.44 200,000 2.40 3.36 300,000 4.80 8.16 EPS Indifference Point 10.00 8.00 6.00 EPS 4.00 2.00 0.00 -2.00 0 100,000 200,000 Sales 300,000 400,000 0.00 -2.00 0 100,000 200,000 Sales 300,000 400,000 of EPS to Debt Ratio 30% 40% 50% 60% 70% 50% 60% 70% Debt Ratio to Debt Ratio 30% 40% Debt Ratio ifference Point 0% Debt 50% Debt 00,000 Sales 300,000 400,000 00,000 Sales 300,000 400,000 Capital Structure Homework Problems 1. Lambdoid Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Lambdoid would have 200,000 shares of stock outstanding. Under Plan II, there would be 100,000 shares of stock outstanding and $4 million in debt outstanding. The interest rate on the debt is 10% and there are no taxes. a. If EBIT is $500,000, which plan will result in higher EPS? b. If EBIT is $3.5 million, which plan will result in higher EPS? c. What is the break-even EBIT? 2. The Lancet Co. is comparing two different capital structures. Plan I would result in 800 shares of stock and $14,000 in debt. Plan II would result in 900 shares of stock and $7000 in debt. The interest rate on the debt is 11%. a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $5000. The all-equity plan would result in 1000 shares outstanding. Which of the three plans has the highest EPS? The lowest? 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 38%. Are the break-even levels of EBIT different from before? Why or why not? 3. A small retailer is considering the advantages of adding debt to the business' capital structure. Currently, $400,000 of assets have been financed entirely with 20,000 shares of common stock. The retailer is considering repurchase of 50% of the equity using proceeds from a bond issue that will require payment of 10% coupon interest. EBIT is projected to be $88,000 for next year, and the applicable corporate income tax rate is 40%. a. Calculate earnings per share under the current all-equity financing and under the bond issue alternative. b. Calculate EPS given an 80% repurchase. Should the retailer be encouraged to take on a higher debt-equity ratio? 4. American Presidential is currently financing its $250,000 million in assets with 10 million shares of common stock. American is thinking of replacing its all-equity capital structure with a new capital structure containing 10% preferred stock, 40% debt, and 50% equity. The preferred stock bears a 6% dividend rate and debt pays a coupon of 9%. Projected EBIT is $40 million and the corporate tax rate is 34%. c. Calculate earnings per share under the current all-equity capital structure and under the alternative financing plan. d. At what EBIT will American be indifferent between the two capital structure alternatives