CHAPTER 24
ASSESSING LONG-TERM DEBT,
EQUITY AND CAPITAL STRUCTURE
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS I. Questions
1. Capital structure is the composition of a firm’s financing, which consists of its permanent sources of capital.
2. The financial manager’s objective in making capital structure decisions is to find the financing mix that maximizes the market value of the firm. This structure is called the optimal capital structure.
3. Under idealized conditions with no income taxes, the traditional approach to capital structure suggests that there is an optimal capital structure which simultaneously maximizes the firm’s market value and minimizes its weighted average cost of capital.
Under idealized conditions with no income taxes, the Modigliani and Miller model implies that the total market value and cost of capital are independent of a firm’s capital structure.
Under idealized conditions with corporate income taxes, the Modigliani and Miller model concludes that leverage affects value, and that firms should be financed with virtually all debt.
Under relaxed assumptions, the contemporary approach suggests that there is an optimal range for the capital structure of the firm. If the firm finances outside this range, the value of the firm will decline.
4. Choosing an optimal or target capital structure involves tradeoff among opposing benefits and costs and requires the use of both analytical techniques and informed judgment.
5. A firm can analyze its capital structure by performing an EBIT – EPS analysis; assessing risk associated with various capital structures; computing debt management ratios and comparing them with industry standards; and seeking the opinion of lenders, investment analysts, and investment bankers. EBIT – EPS analysis is useful for evaluating the sensitivity of EPS to changes in EBIT under various financing plans.
6. The indifference point is the EBIT level at which EPS is equal under alternate financing plans. This point may be found either graphically or mathematically.
7. EBIT – EPS analysis may be criticized because it does not directly consider the long-run financial consequences of financing alternatives and concentrates on earnings maximization rather than wealth maximization.
8. Capital structure decisions are tempered by such considerations as cash flow, market conditions, profitability and stability, control, management preferences, financial flexibility, and business risk.
II. Multiple Choice Questions
1. D 4. B 7. D 10. D
2. D 5. B 8. C 3. A 6. D 9. A III. Problems
Problem 1
For the following problem, assume that:
kd = Cost of debt
I = Interest
ks = Cost of equity
V = Market value of the firm
ka = Weighted average cost of capital
EBIT = Earnings before interest and taxes
(a)
Substituting kd = 0.08 and I = P80,000 and solving for D, the marketvalue of debt is:
P80,000 D = 0.08 P80,000 0.08 = D
Substituting EBIT = P800,000, I = P80,000, and ks = 0.12, the market
value of equity is:
Substituting D = P1,000,000 and S = P6,000,000, the total market value of the firm is:
(b) Substituting EBIT = P800,000 and V = P7,000,000, the weighted average cost of capital is:
Problem 2
(a)
Substituting kd = 0.08 and I = P200,000 and solving for D, the marketvalue of debt is:
P800,000 − P80,000 0.12 = P6,000,000 = S P720,000 0.12 = = P7,000,000 V = P1,000,000 + P6,000,000 = 0.1143 or 11.43% P800,000 P7,000,000 = ka P200,000 D = P2,500,000 = 0.08 P200,000 0.08 = D
Substituting EBIT = P800,000, I = P200,000, and ks = 0.125, the market
value of equity is:
Substituting D = P2,500,000 and S = P4,800,000, the total market value of the firm is:
(b) Substituting EBIT = P800,000 and V = P7,300,000, the weighted average cost of capital is:
(c) The market value of the firm (V) has increased and the weighted average cost of capital (ka) has decreased with the use of additional debt. Thus,
the firm is operating in a world as viewed by the traditionalists. Problem 3
(a) According to the MM approach, the market value of the firm remains unchanged at P7,000,000 with increased leverage.
(b) According to the MM approach, the weighted average cost of capital remains unchanged at 11.43 percent with increased leverage.
(c) Substituting V = P7,000,000 and D = P2,500,000 and solving for S, the
P800,000 − P200,000 0.125 = P4,800,000 = S P600,000 0.125 = = P7,300,000 V = P2,500,000 + P4,800,000 = 0.1096 or 10.96% P800,000 P7,300,000 = ka
Substituting EBIT = P800,000, I = P200,000, and S = P4,500,000, the cost of equity is:
Problem 4
(a) Since the firm has no debt, the market value of the firm is found by multiplying the ordinary equity share selling price per share by the number of shares outstanding:
S = (P25) (400,000) = P10,000,000
(b) Substituting EBIT = P1,500,000 and S = P10,000,000, the cost of equity is:
Problem 5
(a) Weighted Average Costs of Capital Computation
Source of
Capital A B
Debt (0.30 x 0.08) = 24% (0.60 x 0.10) = 6%
Equity (0.70 x 0.14) = 9.8% (0.40 x 0.18) = 7.2%
Total 12.2% 13.2%
(b) Capital Structure A is less costly.
= 0.1333 or 13.33% P800,000 − P200,000 P4,500,000 = ks = 0.1500 or 15.00% P1,500,000 P10,000,000 = ks
Problem 6
(a) The value of Rocky Road Corporation with no leverage is:
(b) 1. The value of Rocky Road Corporation with P1,000,000 in debt is:
2. The total market value with P2,000,000 in debt is:
Due to the tax shelter, the firm is able to increase its value in a linear manner with more debt.
Problem 7
(a) The market value of the firm under each capital structure is: Capital Structure Vu NTD FD V1 A P40,000,000 + P 600,000 − P 0 = P40,600,000 B P40,000,000 + P1,200,000 − P 100,000 = P41,100,000 = P3,300,000 (P750,000) (1− 0.34) 0.15 = Value of the firm with
no leverage
P495,000 0.15 =
= Value of the firm with
leverage P3,300,000 + (0.34) (P1,000,000)
= P3,640,000
= Value of the firm with
leverage P3,300,000 + (0.34) (P2,000,000)
Capital Structure D is preferred because it provides the greatest market value of the firm.
(b) The major problem in using the contemporary approach is estimating the various inputs. This approach is relatively easy to apply in theory but difficult to use in practice.
Problem 8
(a) Substituting I = P720,000 (0.09 x P8,000,000), the financial break-even point under Plan A is:
Plan A Fb = P720,000
Under Plan B, the firm does not have any fixed financial costs (interest or preferred share dividends). Thus the financial breakeven point under Plan B is:
Plan B Fb = P 0
(b) The EBIT – EPS indifference point is:
Cross multiplying:
(750) (0.66 EBIT* – P475.20) = (500) (0.66 EBIT*)
495 EBIT* – P356,400 = 330 EBIT*
165 EBIT* = P356,400
EBIT* = P2,160 (in thousands)
or P2,160,000 (EBIT* – P720) (1 − 0.34) – P 0
500 = (EBIT* – P 0) (1 − 0.34) – P 0750
=
EPS (debt) EPS (ordinary equity share)
0.66 EBIT* – P475.20
(c) The EPS are calculated as follows: Plan A: Debt Plan B: Ordinary Equity Share EBIT P2,750,000 P2,750,000
Less: Interest on new debt 720,000 0
Earnings before taxes 2,030,000 2,750,000
Less: Income taxes (34%) 690,200 935,000
Net income P1,339,800 P1,815,000
Ordinary equity shares 500,000 750,000
Earnings per share P2.68 P2.42
(d) Valdez Sporting Goods should adopt Plan A if it can be reasonably sure that the EBIT will not drop below the indifference point. Although Plan A results in a higher EPS than Plan B, debt financing involves greater risk than ordinary equity share financing.
Problem 9
(a) The interest on existing debt is P2,200,000 (0.11 x P20,000,000) and the interest on the new debt is P1,000,000 (0.10 x P10,000,000). Substituting I1 = P3,200,000, I2 = P2,200,000, PD = P525,000 (P5.25 x 100,000), T =
0.34, n1 = 2,000,000, and n2 = 2,500,000 (with thousands of pesos
omitted), the EBIT – EPS indifference point is:
Cross multiplying:
(EBIT* – P3,200) (1 − 0.34) – P525
2,000 = (EBIT* – P2,200) (1 − 0.34) – P5252,500
=
EPS (debt) EPS (ordinary equity share)
0.66 EBIT* – P2,112 – P525
(b) No. The difference point only identifies the level of EBIT where the EPS of two financing alternatives are equal. The risk associated with the financing alternatives is not reflected by the indifference point.
(c) Using the maximization of EPS as the criterion, ordinary equity share financing would be favored below P7,995,455 and debt financing above P7,995,455.
(d) Substituting ri = P7,995,455, = P9,500,000, and σ = P1,500,000, the ȓ z
value is:
The area under the normal curve with a z = – 1.00 is 0.3413. The probability that EBIT will be below the indifference point of P7,995,455 is 0.1587 (0.5000 – 0.3413), or 15.87 percent.
(e) The EPS are calculated as follows:
Plan 1: Debt Plan 2: Ordinary Equity Share EBIT P9,500,000 P9,500,000
Less: Interest on existing debt 2,200,000 2,200,000
Interest on new debt 1,000,000 0
Earnings before taxes 6,300,000 7,300,000
Less: Income taxes (34%) 2,142,000 2,482,000
Net income 4,158,000 4,818,000
Less: Preferred share dividends 525,000 525,000
Earnings available to ordinary
equity shareholders P3,633,000 P4,293,000
Ordinary equity shares 2,000,000 2,500,000
Earnings per share P1.82 P1.72
(f) If the expected EBIT is P9,500,000, debt financing should be recommended because it provides a higher EPS than ordinary equity share financing with an acceptable level of risk. There is a 15.87 percent probability that the indifference point will not be reached.
P7,995,455 – P9,500,000 P1,500,000 = z – P1,504,545 P1,500,000 = = – 1.00 (rounded)
