Integrativelong dash

Optimal capital structure CountryTextiles, which has fixed operating costs of $ 292 comma 000

$292,000 and variable operating costs equal to 40 %

40% ofsales, has made the following three salesestimates, with their probabilities noted.

The firm wishes to analyze five possible capital structureslong dash

0 %

0%, 15 %

15%, 30 %

30%, 45 %

45%, and 60 %

60% debt ratios. Thefirm's total assets of $ 1.03

$1.03 million are assumed to be constant. Its common stock has a book value of $ 25

$25 pershare, and the firm is in the 40 %

40% tax bracket. The following additional data have been gathered for use in analyzing the five capital structures under consideration.

Sales

Probability

$ 595 comma 000

$595,000

0.25

0.25

907 comma 000

907,000

0.50

0.50

1 comma 190 comma 000

1,190,000

0.25

0.25

Capital structure

debt ratio

Before-tax

cost ofdebt, r Subscript d

rd

Required

return, r Subscript s

rs

0 %

0%

0.0 %

0.0%

10.1 %

10.1%

15

15

7.9

7.9

10.6

10.6

30

30

10.2

10.2

11.7

11.7

45

45

13.2

13.2

14.1

14.1

60

60

16.8

16.8

20.1

20.1

a. Calculate the level of EBIT associated with each of the three levels of sales.

b. Calculate the amount ofdebt, the amount ofequity, and the number of shares of common stock outstanding for each of the five capital structures being considered.

c. Calculate the annual interest on the debt under each of the five capital structures being considered.(Note: Thebefore-tax cost ofdebt, rd, is the interest rate applicable to all debt associated with the corresponding debtratio.)

d. Calculate the EPS associated with each of the three levels of EBIT calculated in part (a) for each of the five capital structures being considered.

e. Calculate(1) the expectedEPS, (2) the standard deviation ofEPS, and(3) the coefficient of variation of EPS for each of the five capitalstructures, using your findings in part (d).

f. Plot the expected EPS and coefficient of variation of EPS against the capital structures (xaxis) on separate sets ofaxes, and comment on the return and risk relative to capital structure.

g. Using theEBIT-EPS data developed in part (d), plot the 0 %

0%, 30 %

30%, and 60 %

60% capital structures on the same set ofEBIT-EPS axes, and discuss the ranges over which each is preferred. What is the major problem with the use of this

approach?

h. Using the valuation model given in the equarion Upper P 0 equals EPS divided by r Subscript s

P0=EPS/rs and your findings in part (e), estimate the share value for each of the capital structures being considered.

i. Compare and contrast your findings in parts (f) and (h). Which structure is preferred if the goal is to maximizeEPS? Which structure is preferred if the goal is to maximize sharevalue? Which capital structure do yourecommend? Explain.

Integrativelong dash

Optimal capital structure CountryTextiles, which has fixed operating costs of $ 292 comma 000

$292,000 and variable operating costs equal to 40 %

40% ofsales, has made the following three salesestimates, with their probabilities noted.

The firm wishes to analyze five possible capital structureslong dash

0 %

0%, 15 %

15%, 30 %

30%, 45 %

45%, and 60 %

60% debt ratios. Thefirm's total assets of $ 1.03

$1.03 million are assumed to be constant. Its common stock has a book value of $ 25

$25 pershare, and the firm is in the 40 %

40% tax bracket. The following additional data have been gathered for use in analyzing the five capital structures under consideration.

Sales

Probability

$ 595 comma 000

$595,000

0.25

0.25

907 comma 000

907,000

0.50

0.50

1 comma 190 comma 000

1,190,000

0.25

0.25

Capital structure

debt ratio

Before-tax

cost ofdebt, r Subscript d

rd

Required

return, r Subscript s

rs

0 %

0%

0.0 %

0.0%

10.1 %

10.1%

15

15

7.9

7.9

10.6

10.6

30

30

10.2

10.2

11.7

11.7

45

45

13.2

13.2

14.1

14.1

60

60

16.8

16.8

20.1

20.1

a. Calculate the level of EBIT associated with each of the three levels of sales.

b. Calculate the amount ofdebt, the amount ofequity, and the number of shares of common stock outstanding for each of the five capital structures being considered.

c. Calculate the annual interest on the debt under each of the five capital structures being considered.(Note: Thebefore-tax cost ofdebt, rd, is the interest rate applicable to all debt associated with the corresponding debtratio.)

d. Calculate the EPS associated with each of the three levels of EBIT calculated in part (a) for each of the five capital structures being considered.

e. Calculate(1) the expectedEPS, (2) the standard deviation ofEPS, and(3) the coefficient of variation of EPS for each of the five capitalstructures, using your findings in part (d).

f. Plot the expected EPS and coefficient of variation of EPS against the capital structures (xaxis) on separate sets ofaxes, and comment on the return and risk relative to capital structure.

g. Using theEBIT-EPS data developed in part (d), plot the 0 %

0%, 30 %

30%, and 60 %

60% capital structures on the same set ofEBIT-EPS axes, and discuss the ranges over which each is preferred. What is the major problem with the use of this

approach?

h. Using the valuation model given in the equarion Upper P 0 equals EPS divided by r Subscript s

P0=EPS/rs and your findings in part (e), estimate the share value for each of the capital structures being considered.

i. Compare and contrast your findings in parts (f) and (h). Which structure is preferred if the goal is to maximizeEPS? Which structure is preferred if the goal is to maximize sharevalue? Which capital structure do yourecommend? Explain.