151

CHAPTER 15
Leverage and the Debt-Equity Mix

QUESTIONS
1. In what way is business leverage similar to physical leverage? Both types of leverage
involve magnification. In both, we carefully construct our system to produce the magnified
result. The differences are in what is magnified income vs. physical force, and what serves
as the lever fixed costs vs. a mechanical device.
2. Distinguish between operating leverage and financial leverage. Both operating and
financial leverage result in the magnification of changes to earnings due to the presence of
fixed costs in a company's cost structure. The difference is only the part of the income
statement we are looking at. Operating leverage is the magnification on the top half of the
income statement how EBIT changes in response to changes in sales; the relevant fixed cost
is the fixed cost of operating the business. Financial leverage is the magnification on the
bottom half of the income statement how earnings per share changes in response to changes
in EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest.
3. How much choice does a firm have over its operating leverage? Over its financial
leverage? Choice over operating leverage depends on the technologies available to a
company. Some companies have little control over their operating leverage. For example,
airlines which have no substitute for airplanes and their associated support systems can
only operate with a large investment in fixed assets that create fixed costs. Other companies
have a significant degree of control over their operating leverage. Many manufacturing
companies, for example, can choose to produce using automated equipment or piecework
labor. By contrast, most firms have total control over their financial leverage through their
choice of financing (the exception is small firms that have limited access to financial markets,
hence limited financing alternatives). A company can increase its financial leverage by using
debt financing and can avoid financial leverage through financing with equity.
4. Describe the way in which earnings per share responds to changing EBIT in a firm
with:
a. No fixed financing costs. A firm with no fixed financing costs has no financial leverage.
In such a firm, earnings per share will rise and fall with EBIT by the same percentage. For
example, a 15% increase in EBIT will result in a 15% increase in EPS; a 9% decrease in
EBIT will result in a 9% decrease in EPS.

152

Chapter 15

b. Some fixed financing costs. A firm with some fixed financing costs does have financial
leverage. In such a firm, earnings per share will rise and fall with EBIT by a greater
percentage. For example, a 15% increase in EBIT will result in a more-than-15% increase
in EPS; a 9% decrease in EBIT will result in a more-than-9% decrease in EPS.
5. How does a firm's financial leverage affect: Financial leverage changes a firm's returns and
risk.
a. Its profitability? Financial leverage changes a firm's earnings per share. To the left of the
indifference point (lower EBIT) between financing alternatives (refer to Figure 15.4, p.
533) financial leverage reduces EPS. To the right of the indifference point (greater EBIT)
EPS is increased as the firm takes on financial leverage. This observation indicates the
importance of knowing the indifference point and where a company's level of EBIT is
relative to it.
b. Its level of risk? Financial leverage increases the volatility of a firm's earnings per share.
As a firm increases its financial leverage, its EPS will rise and fall by magnified amounts in
response to changes in EBIT. This makes the EPS stream riskier for investors. Also, the
possibility that EPS could be lower than if there were less financial leverage (if EBIT is left
of the indifference point) and the power over the firm given to creditors should the firm
have difficulty paying its debts create additional risks for shareholders.
6. A firm is considering two alternative capital structures, and has calculated its
profitability at various EBIT levels under each structure. What should the firm do if its
projected EBIT is:
a. Below the indifference point? In this case, choose the capital structure with the lower
degree of financial leverage. If EBIT is below (to the left of) the financing indifference
point, higher financial leverage would decrease EPS (lower return) as it increases the
volatility of the EPS stream (higher risk). However, lower financial leverage would
increase EPS (higher return) and decrease the volatility of the EPS stream (lower risk), the
combination preferred by risk-averse investors.
b. Above the indifference point? In this case, the choice of capital structure is not obvious,
since there is a tradeoff between the effects of financial leverage on risk and return. If
EBIT is above (to the right of) the indifference point, higher financial leverage would
increase EPS (higher return) but also increase the volatility of the EPS stream (higher
risk). Lower financial leverage would decrease EPS (lower return) and decrease the
volatility of the EPS stream (lower risk). Further analysis is required to identify which
capital structure provides investors with the best risk-return combination.
7. Compare and contrast the net income approach, net operating income approach,
and traditional approach to the optimal debt-equity mix. Which assumptions do you
find reasonable? Unreasonable? The net income approach, net operating income approach,
and traditional approach are three theoretical frameworks for how a company should set its
debt-equity mix. All three examine how a company's cost of capital changes with the debtequity mix and search for the lowest value of the cost of capital, hence the maximum value of
the firm, to identify the best mix. They reach different conclusions because they make
different assumptions about creditors' and investors' reactions to increasing debt. Each of us

Leverage and the Debt-Equity Mix

153

will have our own feelings about the reasonableness of the assumptions. Without going into
the Modigliani-Miller mathematics, the assumptions of the traditional approach usually seem
most reasonable to most people.
(1) The net income approach makes the simplest assumptions, that neither creditors nor
investors increase their required rates of return as a company takes on debt. The cost of
capital declines as higher-cost equity is replaced with lower-cost debt. This approach
concludes that the optimal financing mix is all debt.
(2) The net operating income approach assumes that creditors do not increase their required
rate of return as a company takes on debt, but investors do. Further, the rate at which
investors increase their required rate of return as the financing mix is shifted toward debt
exactly offsets the weighting away from the more expensive equity and toward the cheaper
debt. The result is that the cost of capital remains constant regardless of the financing
mix. This approach concludes that there is no optimal financing mix any mix is as good
as any other.
(3) The traditional approach assumes that both creditors and investors increase their required
rates of return as a company takes on debt. At first this increase is small, and the
weighting toward lower-cost debt pushes the cost of capital down. Eventually, the rate at
which creditors and investors increase their required rates of return accelerates and
dominates the weighting toward debt, pushing the cost of capital back upward. The result
is that the cost of capital declines with debt and reaches a minimum point before rising
again. This approach concludes that there is a optimal financing mix consisting of some
debt and some equity.
8. What role does each of MM's assumptions play in their theory of the debt-equity
mix? MM's key assumptions and the role played by each are:
(1) Unlimited borrowing and lending is available to all market participants at one rate of
interest. Role: makes the cost of personal and corporate borrowing and lending the same.
(2) Individual margin borrowing is secured by the shares purchased, the borrower's liability is
limited to the value of these shares, there are no costs to bankruptcy. Role: makes the risk
of personal and corporate borrowing and lending the same.
(3) All companies can be grouped into equivalent risk classes. Role: enables investors to
identify companies with identical business risk.
(4) Capital markets are perfect. Role: permits investors to easily and costlessly arbitrage
between securities of companies which differ only in their financing mix.
(5) There are no corporate income taxes. Role: prevents the tax code from making debt
financing more valuable by allowing interest and not dividends as a tax deduction.
(6) Shareholders are indifferent to the form of their returns, all returns are taxed at the same
rate. Role: prevents investors from seeing any difference in value between interest,
dividends, and capital gains.
9. Describe homemade leverage. Homemade leverage is investors' method of substituting
their own borrowing or lending for corporate borrowing. Investors who want more leverage
than a company has taken on can buy the company's stock on margin that is, borrow money
from a broker and use the borrowed funds to pay for a portion of the stock in order to add

154

Chapter 15

to the corporate borrowing. Investors who want less leverage than the company has taken on
can invest a portion of their funds in a risk-free investment to offset some of the corporate
borrowing. MM argued that homemade leverage was a perfect substitute for corporate
borrowing, given their assumptions. As a result, investors do not care how much debt any
firm has since they can use homemade leverage to adjust their overall debt exposure to
precisely reproduce the effect of any level of corporate debt on their returns and risk.
10. Is Professor Miller's personal tax model relevant in today's tax environment? Miller's
personal tax model examined the effect of personal income taxes on the debt-equity mix
decision. He observed that personal income taxes in the U.S. favor equity financing since
profits from equity investments come primarily in the form of capital gains which are taxed
later and at potentially lower rates than interest income from debt investments. Miller
determined that the bias in personal income taxes toward equity essentially offset the bias
toward debt in the corporate income tax code and concluded that this supported the original
MM conclusion that the financing mix is irrelevant to a company's value. Since the time
Miller wrote, the difference between the tax rates on ordinary income and capital gains has
narrowed, somewhat weakening his argument. With today's personal tax rate structure, it is
likely that the bias toward debt from the corporate income tax dominates the favoring of
equity by personal taxes. However, some politicians continue to advocate for further
reductions in capital gains tax rates; if this happens, we will once again move closer to Miller's
conclusions.
11. What are the variables that enter compromise theory? What is the effect of each on the
optimal debt-equity mix? In compromise theory, the value of a levered firm equals the value
of the same firm without leverage modified by the impact of three factors:
(1) Corporate income taxes the bias toward debt in the corporate income tax code adds
value to companies with debt financing.
(2) Bankruptcy costs the increased probability of loss should a company be unable to
service its debt subtracts value from companies with debt financing.
(3) Agency costs the increased difficulty of aligning management actions with shareholder
needs in a company with debt subtracts value from companies with debt financing.
12. Define the meaning of each letter of FRICTO, and give an illustration of
each. FRICTO is an acronym summarizing important issues that affect the debt-equity mix
decision in practice:
(1) F = flexibility the impact of alternative financing choices on the firm's future ability to
raise funds in any form required. A company with flexibility will not be shut out of the
financial markets nor forced to take a type of financing that is not its preferred choice.
(2) R = risk the impact of alternative financing choices on the risks faced by the firm and
its stakeholders. In general, taking on additional debt adds to the risks of creditors and
shareholders.
(3) I = income the impact of alternative financing choices on the firm's income stream. A
firm with EBIT above the financing indifference point that increases its debt will increase
its earnings per share.

Leverage and the Debt-Equity Mix

155

(4) C = control the impact of alternative financing choices on each shareholder's amount of
control of the firm. In general, selling additional shares of common equity will dilute each
shareholder's control.
(5) T = timing the impact of market conditions on alternative financing choices. Financial
market conditions often favor one or another kind of financing.
(6) O = other the impact of alternative financing choice on other issues and vice versa. An
example is the ability to use collateral to reduce the cost and risks of debt financing.
13. What is meant by the pecking order approach? Give three explanations why it is an
observed phenomenon. The pecking order approach is a sequence of raising financing that
many companies seem to follow, even though it ignores the recommendations of the various
debt-equity-mix theories. The approach is to finance first with retained earnings, second with
payables and bank debt, third with bonds and other more complex debt, and fourth with
common stock issues. Three explanations for the pecking order approach are:
(1) It is the easiest way for financial managers to obtain funds since it requires the least
amount of work and limits the need for potentially complex negotiations.
(2) It raises funds in the order of low to high flotation costs, keeping these costs to a
minimum.
(3) The financial markets often take the announcement of a stock sale as negative information,
assuming that management would only sell new shares if its share price were high, hence
the stock was overvalued. When management announces a stock sale, it signals this
previously inside information (asymmetric information) to the markets. By putting stock
sales last on the list, the financial manager minimizes the possibility of this reduction in the
firm's share price taking place.

PROBLEMS
SOLUTION PROBLEM 151
(a) Construct an income statement
Sales
$5,000,000
Variable costs 2,250,000

45% of $5 million

156

Chapter 15

Contribution
Fixed costs
EBIT
Interest
EBT
Taxes
EAT
#shares
EPS

2,750,000
1,000,000
1,750,000
0
1,750,000
612,500
1,137,500
1,000,000
$1.14

35% of $1,750,000

From the statement: EBIT = $1,750,000

EPS = $1.14
(b) Redo the income statement
Sales
Variable costs
Contribution
Fixed costs
EBIT
Interest
EBT
Taxes
EAT
#shares
EPS

Sales up 5%
$5,250,000
2,362,500
2,887,500
1,000,000
1,887,500
0
1,887,500
660,625
1,226,875
1,000,000
$1.23

From the statements:

EBIT =
$1,887,500
EPS =
$1.23

Sales down 5%
$4,750,000
2,137,500
2,612,500
1,000,000
1,612,500
0
1,612,500
564,375
1,048,125
1,000,000
$1.05
$1,612,500
$1.05

(c) For sales up by 5%:

EBIT went from $1,750,000 to $1,887,500, an increase of
1,887,500 1,750,000 = 7.86%
1,750,000
EPS went from $1.14 to $1.23, an increase of
$1.23 1.14
= 7.89%
1.14

45%
no change

35%

Leverage and the Debt-Equity Mix

157

For sales down by 5%:

EBIT went from $1,750,000 to $1,612,500, a decrease of
1,612,500 1,750,000 = 7.86%
1,750,000
EPS went from $1.14 to $1.05, a decrease of
$1.05 1.14
= 7.89%
1.14
(d) In all cases, EBIT and EPS change by the same percentage (within round-off error). Observe
the following:
(1) Since this company has fixed operating costs, it has operating leverage. EBIT changes
by more than sales (7.86% vs. 5%).
(2) Since this company has no fixed financing costs (no interest), it has no financial
leverage. EPS changes by the same percentage as EBIT.
(3) Leverage is symmetrical the changes are the same regardless of whether sales is
increasing or decreasing.

SOLUTION PROBLEM 152

(a) Construct an income statement
Sales
Variable costs
Contribution
Fixed costs
EBIT
Interest
EBT

$5,000,000
3,250,000
1,750,000
0
1,750,000
750,000
1,000,000

65% of $5 million

158

Chapter 15

Taxes
EAT
#shares
EPS

350,000
650,000
1,000,000
$0.65

35% of $1 million

From the statement: EBIT = $1,750,000

EPS = $0.65
(b) Redo the income statement
Sales
Variable costs
Contribution
Fixed costs
EBIT
Interest
EBT
Taxes
EAT
#shares
EPS

Sales up 5%
$5,250,000
3,412,500
1,837,500
0
1,837,500
750,000
1,087,500
380,625
706,875
1,000,000
$0.71

From the statements:

EBIT =
$1,837,500
EPS =
$0.71

Sales down 5%
$4,750,000
3,087,500
1,662,500
0
1,662,500
750,000
912,500
319,375
593,125
1,000,000
$0.59
$1,662,500
$0.59

(c) For sales up by 5%:

EBIT went from $1,750,000 to $1,837,500, an increase of
1,837,500 1,750,000 = 5.00%
1,750,000
EPS went from $0.65 to $0.71, an increase of
$0.71 0.65
= 9.23%
0.65
For sales down by 5%:
EBIT went from $1,750,000 to $1,662,500, a decrease of
1,662,500 1,750,000 = 5.00%
1,750,000
EPS went from $0.65 to $0.59, a decrease of
$0.59 0.65
= 9.23%

65%
still 0

35%

Leverage and the Debt-Equity Mix

159

0.65
(d) EPS changes by more than EBIT in both cases. Observe the following:
(1) Since this company has no fixed operating costs, it has no operating leverage. EBIT
changes by the same percentage as sales (both by 5.00%).
(2) Since this company has fixed financing costs (interest), it has financial leverage. EPS
changes by a greater percentage than EBIT (9.23% vs. 5.00%).
(3) Leverage is symmetrical the changes are the same regardless of whether sales is
increasing or decreasing.
SOLUTION PROBLEM 153
(a)
EBIT
Interest
EBT
Taxes
EAT
#shares
EPS

Alternative #1
1,000,000
250,000
750,000
262,500
487,500
200,000
$2.44

Alternative #2
1,000,000
350,000
650,000
227,500
422,500
150,000
$2.82

EBIT
Interest
EBT
Taxes
EAT
#shares
EPS

Alternative #1
1,100,000
250,000
850,000
297,500
552,500
200,000
$2.76

Alternative #2
1,100,000
350,000
750,000
262,500
487,500
150,000
$3.25

EBIT
Interest
EBT

Alternative #1
900,000
250,000
650,000

Alternative #2
900,000
350,000
550,000

(b)

(c)

35%

35%

1510
Taxes
EAT
#shares
EPS

Chapter 15
227,500
422,500
200,000
$2.11

192,500
357,500
150,000
$2.38

35%

(d) Alternative #2 has the greater amount of leverage since it has higher fixed costs (interest). In
these examples, EBIT is high enough so that Alternative #2 provides the greater amount of
EPS, hence the higher returns. But alternative #2 also has the higher level of risk. Under
Alternative #1, EPS swings from $2.44 down to $2.11(13.52%) and up to $2.76(+13.11%).
Under Alternative #2, EPS swings from $2.82 down to $2.38(15.60%) and up to
$3.25(+15.25%), a greater range in percentage terms. There is a tradeoff here between
returns and risk.
SOLUTION PROBLEM 154
(a)
EBIT
Interest
EBT
Taxes
EAT
#shares
EPS

Alternative #1
8,000,000
2,250,000
5,750,000
2,012,500
3,737,500
1,000,000
$3.74

Alternative #2
8,000,000
4,000,000
4,000,000
1,400,000
2,600,000
800,000
$3.25

EBIT
Interest
EBT
Taxes
EAT
#shares
EPS

Alternative #1
9,200,000
2,250,000
6,950,000
2,432,500
4,517,500
1,000,000
$4.52

Alternative #2
9,200,000
4,000,000
5,200,000
1,820,000
3,380,000
800,000
$4.23

EBIT
Interest
EBT
Taxes

Alternative #1
6,800,000
2,250,000
4,550,000
1,592,500

Alternative #2
6,800,000
4,000,000
2,800,000
980,000

(b)

(c)

35%

35%

35%

Leverage and the Debt-Equity Mix

EAT
#shares
EPS

2,957,500
1,000,000
$2.96

1511
1,820,000
800,000
$2.28

(d) Alternative #2 has the greater amount of leverage since it has higher fixed costs (interest). In
this example, however, EBIT is not high enough for Alternative #2 to provide the greater
returns Alternative #2 has lower returns (lower EPS) than Alternative #1. Also, Alternative
#2 has the higher level of risk. Under Alternative #1, EPS swings from $3.74 down to
$2.96(20.86%) and up to $4.52(+20.86%). Under Alternative #2, EPS swings from $3.25
down to $2.28(29.85%) and up to $4.23(+30.15%), a greater range in percentage terms.
Alternative #1 is clearly preferable to Alternative #2.
SOLUTION PROBLEM 155
(a) Try a couple of values for EBIT and calculate EPS for each:
Plan A: EBIT = $500,000 EPS = $0
EBIT = $3,000,000 EPS = $4.06
Plan B: EBIT = $800,000 EPS = $0
EBIT = $3,000,000 EPS = $5.72
Plot these points and join them with a straight line:
EPS ($)
6

5
A

4
3
2
1
1

3
EBIT ($million)

1,300,000

(b)

(EBIT iA)(1t) = (EBIT iB)(1t)

SharesA
SharesB
(EBIT 500,000)(1.35)

(EBIT 800,000)(1.35)

1512

Chapter 15
400,000

250,000

400,000(EBIT 800,000) = 250,000(EBIT 500,000)

400,000EBIT 320,000,000,000 = 250,000EBIT 125,000,000,000
150,000EBIT = 195,000,000,000
EBIT = 1,300,000
(c)
EPS

= (EBIT i)(1t)
#shares

Use either alternative, since EPS is the same at this level of EBIT. Using Alternative A:
EPS =

(1,300,000 500,000)(1.35) = 800,000(.65) = $1.30

400,000
400,000

(d) Looking at the graph, EPS is higher:

Plan A - left of break-even, i.e., for EBIT < $1,300,000
Plan B - right of break-even, i.e., for EBIT > $1,300,000

SOLUTION PROBLEM 156

(a) Try a couple of values for EBIT and calculate EPS for each:
Plan X: EBIT = $2,000,000 EPS = $0
EBIT = $6,000,000 EPS = $10.40
Plan Y: EBIT = $1,200,000 EPS = $0
EBIT = $6,000,000 EPS = $6.93
Plot these points and join them with a straight line:

Leverage and the Debt-Equity Mix

1513

EPS ($)
12

10
Y

8
6
4
2
1

5
6
EBIT ($million)

3,000,000

(b)

(EBIT iX)(1t)
SharesX

(EBIT 2,000,000)(1.35) =
250,000

(EBIT iY)(1t)
SharesY
(EBIT 1,200,000)(1.35)
450,000

250,000EBIT 300,000,000,000 = 450,000EBIT 900,000,000,000

200,000EBIT = 600,000,000,000
EBIT = 3,000,000
(c)

EPS

(EBIT i)(1t)
#shares

Use either plan, since EPS is the same at this level of EBIT. Using Plan X:
(3,000,000 2,000,000)(1.35) = 1,000,000(.65) = $2.60
250,000
250,000
(d) Looking at the graph, EPS is higher:
Plan X - right of break-even, i.e., for EBIT > $3,000,000
Plan Y - left of break-even, i.e., for EBIT < $3,000,000
EPS =

SOLUTION PROBLEM 157

(a) The optimal debt-equity mix is the one which minimizes the cost of capital.
(b)
Debt

Percent

Cost of

Percent

Cost of

Cost of

1514

Chapter 15

ratio
0%
10
20
30

:
:
:
:
:

debt
0%
10
20
30

40
50
60
70
80

:
:
:
:
:

40
50
60
70
80

debt
4.0%
4.0
4.0
4.2
4.5
4.9
5.4
6.2
7.5

equity
100%
90
80
70
60
50
40
30
20

equity
10.5%
11.0
11.6
12.4
13.6
15.3
17.8
21.5
26.0

capital
10.50%
10.30
10.08
9.94

9.96
10.10
10.36
10.79
11.20

(c) The optimal mix is 30% debt and 70% equity. At this mix, the cost of
capital reaches its minimum value of 9.94%.
(d) The traditionalists argue that both debt and equity investors increase their required rates of
return as the firm takes on more debt due to the increasing risk they must bear. The change is
slow at first, as a small amount of debt does not cause much risk, but required rates rise more
rapidly as the mix continues to move toward more debt.

SOLUTION PROBLEM 158

(a)
Debt
ratio
0%
10
20
30
40

:
:
:
:
:
:

Percent
Cost of
Percent
Cost of
Cost of
debt
debt
+ equity equity = capital
0%
3.5%
100%
9.0%
9.00%
10
3.5
90
9.0
8.45
20
3.5
80
9.2
8.06
30
3.5
70
9.6
7.77
40
3.7
60
10.2
7.60

50

50

4.0

50

11.4

7.70

Leverage and the Debt-Equity Mix

60
70
80

:
:
:

60
70
80

4.5
5.2
6.2

40
30
20

1515
13.0
15.2
18.2

7.90
8.20
8.60

(b) The optimal mix is 40% debt and 60% equity. At this mix, the cost of
capital reaches its minimum value of 7.60%.
(c)
Debt
ratio
0%

Cost of
debt
Increase
3.5%
0
3.5
0
3.5
0
3.5
0.2%
3.7
0.3%
4.0
0.5%
4.5
0.7%
5.2
1.0%
6.2

10
20
30
40
50
60
70
80

Cost of
equity Increase
9.0%
0
9.0
0.2%
9.2
0.4%
9.6
0.6%
10.2
1.2%
11.4
1.6%
13.0
2.2%
15.2
3.0%
18.2

The pattern is the same for both debt and equity. Small increases in the debt ratio do not
change creditors' nor stockholders' required returns. Larger debt ratios raise required returns,
and by an accelerating rate. Stockholders' required rate of return rises faster than creditors' as
they bear more risk.

(d)
Debt
ratio
0%
10
20
30

:
:
:
:
:

Cost of
equity
9.0%
9.0
9.2
9.6

Cost of
debt = Difference
3.5%
5.5%
3.5
5.5
3.5
5.7
3.5
6.1

1516

Chapter 15

40
50
60
70
80

:
:
:
:
:

10.2
11.4
13.0
15.2
18.2

3.7
4.0
4.5
5.2
6.2

6.5
7.4
8.5
10.0
12.0

These differences confirm the observations of part (c). The cost of equity rises at a faster rate
than the cost of debt due to the greater risk assumed by stockholders.
SOLUTION PROBLEM 159
(a) The compromise theory relationship is:
VLEVERED = VUNLEVERED + CT BC AC
Debt
ratio
0%
10
20
30
40
50
60
70
80

:
:
:
:
:
:
:
:
:
:

VUNLEVERED + CT BC
35,000
0
0

1,000
0

2,000
1,000

3,000
2,000

4,000
4,000

5,000
7,000

6,000
11,000

7,000
16,000

8,000
22,000

AC
0
200
400
700
1,100
1,600
2,200
2,900
3,700

= VLEVERED
35,000
35,800
35,600

35,300

33,900

31,400

27,800

23,100

17,300

(b) The optimal mix is 10% debt and 90% equity. At this mix, the value of
the firm reaches its highest (optimal) value of $35,800,000.

(c) The "acceptable range" appears to be from a little over 0% debt through about 30% debt. In
this region, the firm's value seems to hold close to $35.5 million.
(d) The corporate tax numbers (CT) increase at a constant rate with the debt ratio since they are
related to it in a linear fashion. More debt more interest more tax deductions more
present value of tax benefits. The bankruptcy cost (BC) and agency cost (AC) numbers, on
the other hand, reflect increasing risk perceptions which grow at an accelerating rate as the
debt ratio increases.
SOLUTION PROBLEM 1510

Leverage and the Debt-Equity Mix

1517

(a) The compromise theory relationship is:

VLEVERED = VUNLEVERED + CT BC AC
Debt
ratio
0%
10
20
30
40
50
60
70
80

:
:
:
:
:
:
:
:
:
:

VUNLEVERED + CT
80,000
0

3,000

6,000

9,000

12,000

15,000

18,000

21,000

24,000

BC
0
0
0
4,000
8,000
14,000
22,000
32,000
44,000

AC
0
1,000
1,500
2,200
3,100
4,200
5,500
7,000
8,700

= VLEVERED
80,000
82,000
84,500
82,800

80,900

76,800

70,500

62,000

51,300

(b) The optimal mix is 20% debt and 80% equity. At this mix, the value of
the firm reaches its highest (optimal) value of $84,500,000.

(c) The "acceptable range" appears to be a narrow band around 20% debt. At debt ratios away
from 20%, the firm's value drops off rapidly.
(d) Agency costs arise with the very first dollar of debt since a new stakeholder has been added to
the company. Management must integrate/align the creditors with other stakeholder needs,
creating a potential for loss of value by shareholders. Bankruptcy costs, on the other hand,
only begin when the amount of debt grows large enough to pose default risks.
SOLUTION PROBLEM 1511
(a) Debt ratio
Now =
After

3,000,000 = 30%
10,000,000
= 3,000,000 + 2,000,000
10,000,000

= 50%

(b) There would be $5,000,000 of debt after the change:

Amount
3,000,000
2,000,000

Proportion
60%
40%

Cost
5%
6.5%

Proportion Cost
3.00%
2.60

1518

Chapter 15
5.60%

(c) Now:
Debt
Equity
After:
Debt
Equity

Proportion
30%
70%
50%
50%

Cost
5%
12%
5.6%
14.0%

Proportion Cost
1.50%
8.40
9.90%
2.80%
7.00
9.80%

(d) Other things equal, yes - alter the debt-equity mix. This will reduce the cost of capital and
increase the value of the firm.
SOLUTION PROBLEM 1512
(a) Debt ratio
Now = 40,000,000
50,000,000
After

= 80%

= 40,000,000 15,000,000 = 50%

50,000,000

(b) Cost of Capital

Now:
Debt
Equity
After:
Debt
Equity

Proportion
80%
20%

Cost
10%
19%

Proportion Cost
8.00%
3.80
11.80%

50%
50%

10%
12%

5.00%
6.00
11.00%

6%
12%

3.00%
6.00
9.00%

(c) Refunding the 10% debt:

Debt
Equity

50%
50%

Leverage and the Debt-Equity Mix

1519

(d) Yes - alter the mix and refund the expensive debt. The combined refinancing reduces the cost
of capital from 11.80% to 9%, significantly increasing the value of the firm.

15B1
APPENDIX 15B
Measuring the Degree of Leverage

PROBLEMS
SOLUTION PROBLEM 15B1
Construct the top lines of the company's income statement:
Sales
Variable cost
Contribution

$300,000
120,000
180,000

40% of sales
(1 v) = 60% of sales

Now continue down the income statement for each case:

(a) F = $0
Contribution
Fixed cost
EBIT

180,000
0
$180,000

(b) F = $40,000
Contribution
Fixed cost
EBIT

180,000
40,000
$140,000

(c) F = $80,000
Contribution
Fixed cost
EBIT

180,000
80,000
$100,000

(d) F = $120,000
Contribution
Fixed cost
EBIT

180,000
120,000
$ 60,000

SOLUTION PROBLEM 15B2

15B2

Appendix 15B

Construct the top lines of the company's income statement:

Sales
Variable cost
Contribution

$1,750,000
1,137,500
612,500

65% of sales
(1 v) = 35% of sales

Now continue down the income statement for each case:

(a) F = $0
Contribution
Fixed cost
EBIT

612,500
0
$612,500

(b) F = $150,000
Contribution
Fixed cost
EBIT

612,500
150,000
$462,500

(c) F = $300,000
Contribution
Fixed cost
EBIT

612,500
300,000
$312,500

(d) F = $450,000
Contribution
Fixed cost
EBIT

612,500
450,000
$162,500

SOLUTION PROBLEM 15B3

Redo the income statements of problem 15B1 with sales of $400,000:

Measuring the Degree of Leverage

15B3

(a)
$400,000
160,000
240,000
0
$240,000

(b)
$400,000
160,000
240,000
40,000
$200,000

(c)
$400,000
160,000
240,000
80,000
$160,000

(d)
$400,000
160,000
240,000
120,000
$120,000

180,000

140,000

100,000

60,000

Change to EBIT $ 60,000

$ 60,000

$ 60,000

$ 60,000

Sales
Variable cost
Contribution
Fixed cost
EBIT
EBIT was

Measured in absolute dollars, EBIT increases by $60,000 in all four cases.

Note : 40% of sales, from problem 15B1

Percentage change to EBIT

(a) $60,000/$180,000
(b) $60,000/$140,000
(c) $60,000/$100,000
(d) $60,000/$60,000

= 33.33%
= 42.86%
= 60.00%
= 100.00%

Note:

greater percentage change with

higher fixed costs.

SOLUTION PROBLEM 15B4

Redo the income statements of problem 15B2 with sales of $2,000,000:
Sales
Variable cost
Contribution
Fixed cost
EBIT

(a)
$2,000,000
1,300,000
700,000
0
$ 700,000

(b)
$2,000,000
1,300,000
700,000
150,000
$ 550,000

(c)
$2,000,000
1,300,000
700,000
300,000
$ 400,000

(d)
$2,000,000
1,300,000
700,000
450,000
$ 250,000

612,500

462,500

312,500

162,500

EBIT was
Change to EBIT $

87,500

87,500

87,500

87,500

Measured in absolute dollars, EBIT increases by $87,500 in all four cases.

Note : 65% of sales, from problem 15B2

Percentage change to EBIT

15B4
(a)
(b)
(c)
(d)

Appendix 15B
$87,500/$612,500
$87,500/$462,500
$87,500/$312,500
$87,500/$162,500

=
=
=
=

14.29%
18.92%
28.00%
53.85%

Note:

greater percentage change with

higher fixed costs.

SOLUTION PROBLEM 15B5

(1) Construct income statements for each sales level:
Sales
Variable cost
Contribution
Fixed cost
EBIT

(a)
$700,000
350,000
350,000
300,000
$ 50,000

(b)
$800,000
400,000
400,000
300,000
$100,000

(c)
$900,000
450,000
450,000
300,000
$150,000

(d)
$1,000,000
500,000
500,000
300,000
$ 200,000

(2) Increase each sales number by 10% and construct new income statements:
Sales
Variable cost
Contribution
Fixed cost
EBIT

(a)
$770,000
385,000
385,000
300,000
$ 85,000

(b)
$880,000
440,000
440,000
300,000
$140,000

(c)
$990,000
495,000
495,000
300,000
$195,000

Note : 50% of sales

(3) Compare EBIT levels:

(a) Change = $85,000 $50,000 = $35,000
Percentage change = $35,000 = 70.00%
$50,000
(b) Change = $140,000 $100,000
Percentage change = $40,000
$100,000
(c) Change = $195,000 $150,000
Percentage change = $45,000
$150,000

= $40,000
= 40.00%
= $45,000
= 30.00%

(d) Change = $250,000 $200,000 = $50,000

Percentage change = $50,000
= 25.00%

(d)
$1,100,000
550,000
550,000
300,000
$ 250,000

Measuring the Degree of Leverage

15B5

$200,000
While the absolute change increases as sales goes up, the percentage change decreases as the
firm's EBIT rises.
SOLUTION PROBLEM 15B6
(1) Construct income statements for each sales level:
Sales
Variable cost
Contribution
Fixed cost
EBIT

(a)
$250,000
100,000
150,000
120,000
$ 30,000

(b)
$300,000
120,000
180,000
120,000
$ 60,000

(c)
$350,000
140,000
210,000
120,000
$ 90,000

(d)
$400,000
160,000
240,000
120,000
$120,000

(2) Increase each sales number by 25% and construct new income statements:
Sales
Variable cost
Contribution
Fixed cost
EBIT

(a)
$312,500
125,000
187,500
120,000
$ 67,500

(b)
$375,000
150,000
225,000
120,000
$105,000

(c)
$437,500
175,000
262,500
120,000
$142,500

Note : 40% of sales

(3) Compare EBIT levels:

(a) Change = $67,500 $30,000 = $37,500
Percentage change = $37,500 = 125.00%
$30,000

(b) Change = $105,000 $60,000

Percentage change = $45,000
$60,000

= $45,000
= 75.00%

(c) Change = $142,500 $90,000

Percentage change = $52,500
$90,000

= $52,500
= 58.33%

(d)
$500,000
200,000
300,000
120,000
$180,000

15B6

Appendix 15B

(d) Change = $180,000 $120,000 = $60,000

Percentage change = $60,000
= 50.00%
$120,000
While the absolute change increases as sales goes up, the percentage change decreases as the
firm's EBIT increases.
SOLUTION PROBLEM 15B7
DOL = contribution
EBIT
From problem 15B1:
(a) DOL = $180,000
$180,000
(b) DOL = $180,000
$140,000
(c) DOL = $180,000
$100,000
(d) DOL = $180,000
$ 60,000

= 1

With no fixed operating costs, DOL always = 1

= 1.29

As fixed operating costs rise, EBIT declines

= 1.80 relative to contribution, and DOL rises.

= 3.00

In problem 15B3, sales increased to $400,000 (from $300,000 in problem 15B1), a 33.33%
increase. Applying the DOL numbers from above to the 33.33% change in sales gives the
percentage change in EBIT in problem 15B3:
(a) 33.33%(1) = 33.33%
(b) 33.33%(1.29) = 43.00%, within roundoff of 42.86%
(c) 33.33%(1.80) = 60.00%
(d) 33.33%(3.00) = 100.00%
SOLUTION PROBLEM 15B8
DOL = contribution
EBIT
From problem 15B2:
(a) DOL = $612,500
$612,500

= 1

With no fixed operating costs, DOL always = 1

Measuring the Degree of Leverage

(b) DOL = $612,500

$462,500
(c) DOL = $612,500
$312,500
(d) DOL = $612,500
$162,500

15B7

= 1.32

As fixed operating costs rise, EBIT declines

= 1.96 relative to contribution, and DOL rises.

= 3.77

In problem 15B4, sales increased to $2,000,000 (from $1,750,000 in problem 15B2), a 14.29%
increase. Applying the DOL numbers from above to the 14.29% change in sales gives the
percentage change in EBIT in problem 15B4:
(a) 14.29%(1) = 14.29%

(b) 14.29%(1.32) = 18.86%,

(c) 14.29%(1.96) = 28.01% within roundoff error
(d) 14.29%(3.77) = 53.87%

SOLUTION PROBLEM 15B9

DOL = contribution
EBIT
Prior to the sales increase:
(a) DOL = $350,000
$ 50,000
(b) DOL = $400,000
$100,000
(c) DOL = $450,000
$150,000
(d) DOL = $500,000
$200,000
After the sales increase:

= 7.00

(a) DOL = $385,000

$ 85,000
(b) DOL = $440,000
$140,000
(c) DOL = $495,000
$195,000
(d) DOL = $550,000
$250,000

= 4.53

= 4.00
= 3.00
= 2.50

= 3.14
= 2.54
= 2.20

15B8

Appendix 15B

Note how as sales, hence EBIT, rises, DOL declines.

SOLUTION PROBLEM 15B10
DOL = contribution
EBIT
Prior to the sales increase:
(a) DOL = $150,000
$ 30,000
(b) DOL = $180,000
$ 60,000
(c) DOL = $210,000
$ 90,000
(d) DOL = $240,000
$120,000

= 5.00
= 3.00
= 2.33
= 2.00

After the sales increase:

(a) DOL = $187,500
$ 67,500
(b) DOL = $225,000
$105,000
(c) DOL = $262,500
$142,500
(d) DOL = $300,000
$180,000

= 2.78
= 2.14
= 1.84
= 1.67

Note how as sales, hence EBIT, rises, DOL declines.

SOLUTION PROBLEM 15B11
Construct the bottom lines of the company's income statement:
EBIT
Interest
EBT
Taxes
EAT
# Shares
EPS

(a)
$500,000
0
500,000
175,000
325,000
20,000
$ 16.25

(b)
$500,000
100,000
400,000
140,000
260,000
20,000
$ 13.00

(c)
$500,000
200,000
300,000
105,000
195,000
20,000
$ 9.75

(d)
$500,000
300,000
200,000
70,000
130,000
20,000
$ 6.50

Measuring the Degree of Leverage

15B9

SOLUTION PROBLEM 15B12

Construct the bottom lines of the company's income statement:
EBIT
Interest
EBT
Taxes
EAT
# Shares
EPS

(a)
$2,500,000
0
2,500,000
875,000
1,625,000
150,000
$ 10.83

(b)
$2,500,000
500,000
2,000,000
700,000
1,300,000
150,000
$
8.67

(c)
$2,500,000
1,000,000
1,500,000
525,000
975,000
150,000
$
6.50

(d)
$2,500,000
1,500,000
1,000,000
350,000
650,000
150,000
$ 4.33

SOLUTION PROBLEM 15B13

Redo the income statements of problem 15B11 with EBIT of $550,000:
EBIT
Interest
EBT
Taxes
EAT
# Shares
EPS

(a)
$550,000
0
550,000
192,500
357,500
20,000
$ 17.88

(b)
$550,000
100,000
450,000
157,500
292,500
20,000
$ 14.63

(c)
$550,000
200,000
350,000
122,500
227,500
20,000
$ 11.38

(d)
$550,000
300,000
250,000
87,500
162,500
20,000
$ 8.13

15B10
EPS was
Change to EPS

Appendix 15B
$16.25

$13.00

$ 9.75

$ 6.50

$ 1.63

$ 1.63

$ 1.63

$ 1.63

Measured in absolute dollars, EPS increases by $1.63 in all four cases.

Percentage change to EPS
(a) $1.63/$16.25 = 10.03%
(b) $1.63/$13.00 = 12.54%
(c) $1.63/$ 9.75 = 16.72%
(d) $1.63/$ 6.50 = 25.08%

(10% without roundoff error) Note: greater percentage

(12.50% without roundoff error)
change with higher
(16.67% without roundoff error)
fixed costs (interest).
(25.00% without roundoff error)

SOLUTION PROBLEM 15B14

Redo the income statements of problem 15B12 with EBIT of $3,000,000:
EBIT
Interest
EBT
Taxes
EAT
# Shares
EPS

(a)
$3,000,000
0
3,000,000
1,050,000
1,950,000
150,000
$ 13.00

EPS was

$ 10.83

(b)
$3,000,000
500,000
2,500,000
875,000
1,625,000
150,000
$ 10.83
$

(c)
$3,000,000
1,000,000
2,000,000
700,000
1,300,000
150,000
$
8.67

8.67

6.50

(d)
$3,000,000
1,500,000
1,500,000
525,000
975,000
150,000
$ 6.50
$

4.33

Change to EPS $
2.17
$
2.17
$
2.17
$
2.17
Measured in absolute dollars, EPS increases by $2.17 in all four cases.
Percentage change to EPS
(a) $2.17/$10.83 = 20.04%
(b) $2.17/$ 8.67 = 25.03%
(c) $2.17/$ 6.50 = 33.38%
(d) $2.17/$ 4.33 = 50.12%

(20% without roundoff error) Note: greater percentage

(25% without roundoff error)
change with higher
(33.33% without roundoff error)
fixed costs (interest).
(50% without roundoff error)

SOLUTION PROBLEM 15B15

(1) Construct income statements for each EBIT level:
EBIT

(a)
$400,000

(b)
$600,000

(c)
$800,000

(d)
$1,000,000

Measuring the Degree of Leverage

Interest
EBT
Taxes
EAT
# Shares
EPS

200,000
200,000
70,000
130,000
35,000
$ 3.71

200,000
400,000
140,000
260,000
35,000
$ 7.43

15B11
200,000
600,000
210,000
390,000
35,000
$ 11.14

200,000
800,000
280,000
520,000
35,000
$
14.86

(2) Increase each EBIT number by 10% and construct new income statements:
EBIT
Interest
EBT
Taxes
EAT
# Shares
EPS

(a)
$440,000
200,000
240,000
84,000
156,000
35,000
$ 4.46

(b)
$660,000
200,000
460,000
161,000
299,000
35,000
$ 8.54

(c)
$880,000
200,000
680,000
238,000
442,000
35,000
$ 12.63

(d)
$1,100,000
200,000
900,000
315,000
585,000
35,000
$
16.71

(3) Compare EPS levels:

(a) Change = $4.46 $3.71 = $0.75
Percentage change = $0.75 = 20.22%
$3.71
(b) Change = $8.54 $7.43 =
Percentage change = $1.11
$7.43
(c) Change = $12.63 $11.14
Percentage change = $1.49
$11.14

$1.11
= 14.94%
= $1.49
= 13.38%

(d) Change = $16.71 $14.86 = $1.85

Percentage change = $1.85 = 12.45%
$14.86
While the absolute change increases as EBIT goes up, the percentage change decreases as the
firm's EBT rises.
SOLUTION PROBLEM 15B16
(1) Construct income statements for each EBIT level:

15B12

EBIT
Interest
EBT
Taxes
EAT
# Shares
EPS

Appendix 15B
(a)
$250,000
80,000
170,000
59,500
110,500
12,000
$ 9.21

(b)
$300,000
80,000
220,000
77,000
143,000
12,000
$ 11.92

(c)
$350,000
80,000
270,000
94,500
175,500
12,000
$ 14.63

(d)
$400,000
80,000
320,000
112,000
208,000
12,000
$ 17.33

(2) Increase each EBIT number by 25% and construct new income statements:
EBIT
Interest
EBT
Taxes
EAT
# Shares
EPS

(a)
$312,500
80,000
232,500
81,375
151,125
12,000
$ 12.59

(b)
$375,000
80,000
295,000
103,250
191,750
12,000
$ 15.98

(c)
$437,500
80,000
357,500
125,125
232,375
12,000
$ 19.36

(d)
$500,000
80,000
420,000
147,000
273,000
12,000
$ 22.75

(3) Compare EPS levels:

(a) Change = $12.59 $9.21 = $3.38
Percentage change = $3.38 = 36.70%
$9.21
(b) Change = $15.98 $11.92 = $4.06
Percentage change = $4.06 = 34.05%
$11.92
(c) Change = $19.36 $14.63 = $4.73
Percentage change = $4.73 = 32.33%
$14.63
(d) Change = $22.75 $17.33 = $5.42
Percentage change = $5.42 = 31.28%
$17.33
While the absolute change increases as EBIT goes up, the percentage change decreases as the
firm's EBT rises.
SOLUTION PROBLEM 15B17

Measuring the Degree of Leverage

DFL

15B13

EBIT
earnings before taxes

From problem 15B11:

(a) DFL

= $500,000
$500,000

(b) DFL

= $500,000
$400,000

(c) DFL

= $500,000
$300,000

(d) DFL

= $500,000
$200,000

= 1

With no fixed financing costs (interest),

DFL always = 1

= 1.25

As fixed financing costs (interest) rise, EBT

= 1.67 declines relative to EBIT, and DFL rises.

= 2.50

In problem 15B13, EBIT increased to $550,000 (from $500,000 in problem 15B11), a 10%
increase. Applying the DFL numbers from above to the 10% change in EBIT gives the percentage
change to EPS in problem 15B13:
(a) 10%(1)
= 10.00%
(b) 10%(1.25) = 12.50%
(c) 10%(1.67) = 16.67%
(d) 10%(2.50) = 25.00%
SOLUTION PROBLEM 15B18
DFL

EBIT
earnings before taxes

From problem 15B12:

(a) DFL

(b) DFL
(c) DFL
(d) DFL

= $2,500,000 = 1
$2,500,000

With no fixed financing costs (interest),

DFL always = 1

= $2,500,000 = 1.25
$2,000,000

As fixed financing costs (interest) rise, EBT

= $2,500,000 = 1.67 declines relative to EBIT, and DFL rises.
$1,500,000

= $2,500,000 = 2.50
$1,000,000

15B14

Appendix 15B

In problem 15B14, EBIT increased to $3,000,000 (from $2,500,000 in problem 15B12), a 20%
increase. Applying the DFL numbers from above to the 20% change in EBIT gives the percentage
change to EPS in problem 15B14:
(a) 20%(1)
= 20.00%
(b) 20%(1.25) = 25.00%
(c) 20%(1.67) = 33.33%
(d) 20%(2.50) = 50.00%
SOLUTION PROBLEM 15B19
DFL

EBIT__
earnings before taxes

Prior to the EBIT increase:

(a) DFL

(b) DFL

(c) DFL

(d) DFL

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

2.00

1.50

1.33

1.25

After the EBIT increase:

(a) DFL

= $440,000
= 1.83
$240,000
(b) DFL = $660,000
= 1.43
$460,000
(c) DFL = $880,000
= 1.29
$680,000
(d) DFL = $1,100,000 = 1.22
$900,000
Note how as EBIT, hence EBT rises, DFL declines.
SOLUTION PROBLEM 15B20
DFL

EBIT
earnings before taxes

Prior to the EBIT increase:

Measuring the Degree of Leverage

(a) DFL
(b) DFL
(c) DFL
(d) DFL

= $250,000
$170,000
= $300,000
$220,000
= $350,000
$270,000
= $400,000
$320,000

= 1.47
= 1.36
= 1.30
= 1.25

After the EBIT increase:

(a) DFL
(b) DFL
(c) DFL
(d) DFL

= $312,500
$232,500
= $375,000
$295,000
= $437,500
$357,500
= $500,000
$420,000

= 1.34
= 1.27
= 1.22
= 1.19

Note how as EBIT, hence EBT rises, DFL declines.

SOLUTION PROBLEM 15B21
(a)
Sales
$2,000,000
Variable cost 1,100,000
Contribution
900,000
Fixed cost
600,000
EBIT
300,000
Interest
100,000
EBT
200,000
Taxes
70,000
EAT
130,000
#shares
150,000
EPS
$0.87

55% of sales

(b)
DOL = contribution = $900,000 = 3.00
EBIT
$300,000
DFL

= EBIT = $300,000

= 1.50

15B15

15B16

Appendix 15B
EBT

DTL
(c)

$200,000

= contribution = $900,000 = 4.50

EBT
$200,000

DOL DFL

= 3.00 1.50 = 4.50

(d)
Sales
$2,300,000
Variable cost 1,265,000
Contribution 1,035,000
Fixed cost
600,000
EBIT
435,000
Interest
100,000
EBT
335,000
Taxes
117,250
EAT
217,750
#shares
150,000
EPS
$1.45

up 15%
(55% of sales)

up 45%

up 67%

From DOL, EBIT should increase by 15%(3.00) = 45%

From DFL, EPS should increase by 45%(1.50) = 67.5% (roundoff error)
From DTL, EPS should increase by 15%(4.50) = 67.5%
SOLUTION PROBLEM 15B22
(a)
Sales
$500,000
Variable cost 175,000
Contribution 325,000
Fixed cost
125,000
EBIT
200,000
Interest
50,000
EBT
150,000
Taxes
52,500
EAT
97,500
#shares
75,000
EPS
$1.30
(b)

35% of sales

Measuring the Degree of Leverage

15B17

DOL = contribution = $325,000 = 1.63

EBIT
$200,000

(c)

DFL

= EBIT = $200,000
EBT
$150,000

DTL

= contribution = $325,000 = 2.17

EBT
$150,000

DOL DFL

= 1.33

= 1.63 1.33 = 2.17

(d)
Sales
$625,000
Variable cost
218,750
Contribution 406,250
Fixed cost
125,000
EBIT
281,250
Interest
50,000
EBT
231,250
Taxes
80,938
EAT
150,312
#shares
75,000
EPS
$2.00

up 25%
(35% of sales)

up 40.6%

up 53.9%

From DOL, EBIT should increase by 25%(1.63) = 40.8% (roundoff error)

From DFL, EPS should increase by 40.6%(1.33) = 54.0% (roundoff error)
From DTL, EPS should increase by 25%(2.17)

=
54.3% (roundoff error)17