Computer applications in Finance

Ps : Solving on Excel Please

Optimal Capital Structure $($LO#$3)\_()$

When the weighted average cost of capital $($WACC$)$ is calculated, It is assumed that the firm had

a specific target capital structure. However, target capital structures often change over time, such

changes affect the risk and cost of each type of capital, and all this can change the WACC.

Moreover, a change in the WACC will affect capital budgeting decisions and, ultimately, the stock

price. Many factors influence capital structure decisions, and, as by turn, determining the optimal

capital structure is not an exact science. Therefore, even firms in the same industry often have

dramatically different capital structures. The debt presents a crucial factor that effects on risk and

on the optimal capital structure. In this sense, the finance people should understand and explain

why there may be differences in a firm's capital structure when measured on a book$-$value basis,

a market$-$value basis, or a target basis. They have to distinguish between business risk and financial

risk, and explain the effects that debt financing has on the firm's expected return and risk. In the

same vein, they have to understand the analytical framework used when determining the optimal

capital structure. Moreover, they have to be aware of capital structure theory, and use it to explain

why firms in different industries tend to have different capital structures.

In the light of the above discussion. Apply your understanding of the topic in regards to the

following case:

Assume that you have just been hired as business manager of Campus Deli $($CD$),$ which is located

adjacent to the campus. Sales were $$1,100,000$ last year, variable costs were $60\%$ of sales, and

fixed costs were $$40,000.$ Therefore, EBIT totaled $$400,000.$ Because the university's enrollment

is capped, EBIT is expected to be constant over time. Because no expansion capital is required,

CD distributes all earnings as dividends. Invested capital is $$2$ million, and $80,000$ shares are

outstanding. The management group owns about $50\%$ of the stock, which is traded in the over$-$

outstanding. The management group owns about $50\%$ of the stock, which is traded in the over$-$

the$-$counter market.

CD currently has no debt $-$ it is an all$-$equity firm $-$ and its $80,000$ shares outstanding sell at a price

of $$25$ per share, which is also the book value. The firm's federal$-$plus$-$state tax rate is $40\%.$ On

the basis of statements made in your finance text, you believe that CD$\text{'}$s shareholders would be

better off if some debt financing was used. When you suggested this to your new boss, she

encouraged you to pursue the idea but to provide support for the suggestion.

In today's market, the risk$-$free rate, r$\_($RF$),$ is $6\%,$ and the market risk premium, RP$\_($M$),$ is $6\%.$ CD$\text{'}$s

unlevered beta, bu$,$ is $1\mathrm{.}0.$ CD currently has no debt, so its cost of equity $($and WACC$)$ is $12\%.$ If

the firm was recapitalized, debt would be issued and the borrowed funds would be used to

repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy

equities in other fast$-$food companies similar to CD$.$

Questions

A$.$

What is business risk? What factors influence a firm's business risk?

What is operating leverage, and how does it affect a firm's business risk?

What is the firm's return on invested capital $($ROIC$)?$

B

What do the terms financial leverage and financial risk mean?

How does financial risk differ from business risk?

C$.$

To develop an example that can be presented to CD$\text{'}$s management as an illustration,

consider two hypothetical firms: Firm U with zero debt financing and Firm L with

$$10,000$ of $12\%$ debt. Both firms have $$20,000$ in invested capital and a $40\%$ federal$-$

plus$-$state tax rate, and they have the following EBIT probability distribution for next

year:

$(1)$ Complete the partial income statements and the firms' ratios in following Table

Income Statements and Ratios

Firm U Firm L

Total capital $$20,000$ $$20,000$ $$20,000$ $$20,000$ $$20,000$ $$20,000$

Equity $$20,000$ $$20,000$ $$20,000$ $$10,000$ $$10,000$ $$10,000$

Probability $0\mathrm{.}250\mathrm{.}500\mathrm{.}250\mathrm{.}250\mathrm{.}500\mathrm{.}25$

Sales $ $6,000$ $ $9,000$ $$12,000$ $ $6,000$ $ $9,000$ $$12,000$

Oper. costs $4,0006,0008,0004,0006,0008,000$

EBIT $ $2,000$ $ $3,000$ $ $4,000$ $ $2,000$ $ $3,000$ $ $4,000$

Int. $(12\%)0001,2001,200$

EBT $ $2,000$ $ $3,000$ $ $4,000$ $ $800$ $ $ $2,800$

Taxes $(40\%)8001,2001,6003201,120$

Net income $ $1,200$ $ $1,800$ $ $2,400$ $ $480$ $ $ $1,680$

ROIC $6\mathrm{.}0\%9\mathrm{.}0\%12\mathrm{.}0\%\%\%\%$

ROE $6\mathrm{.}0\%9\mathrm{.}0\%12\mathrm{.}0\%4\mathrm{.}8\%\%16\mathrm{.}8\%$

TIE $1\mathrm{.}73\mathrm{.}3$

E$($ROIC$)9\mathrm{.}0\%\%$

E$($ROE$)9\mathrm{.}0\%10\mathrm{.}8\%$

E$($TIE$)2\mathrm{.}5$

$$ROIC $2\mathrm{.}1\%\%$

$$ROE $2\mathrm{.}1\%4\mathrm{.}2\%$

$$TIE $00\mathrm{.}6$

C$.(2)$ Be prepared to discuss each entry in the table and to explain how this example

illustrates the

G$.$ Put labels on the following Figure and then discuss the graph as you might use it to explain to your boss why CD might want to use some debt.

H$.$ How does the existence of asymmetric information and signaling affect capital structure?