P13-26 Integrative—Optimal capital structure

a. Number of Shares
% Debt Total Assets Debt Equity @$25
0% $ 40,000,000 $ - $ 40,000,000 1,600,000
10% $ 40,000,000 $ 4,000,000 $ 36,000,000 1,440,000
20% $ 40,000,000 $ 8,000,000 $ 32,000,000 1,280,000
30% $ 40,000,000 $ 12,000,000 $ 28,000,000 1,120,000
40% $ 40,000,000 $ 16,000,000 $ 24,000,000 960,000
50% $ 40,000,000 $ 20,000,000 $ 20,000,000 800,000
60% $ 40,000,000 $ 24,000,000 $ 16,000,000 640,000

b. Before-tax Cost of
% Debt Total Debt Interest Expense
Debt
0% $ - 0.0% $ -
10% $ 4,000,000 7.5% $ 300,000
20% $ 8,000,000 8.0% $ 640,000
30% $ 12,000,000 9.0% $ 1,080,000
40% $ 16,000,000 11.0% $ 1,760,000
50% $ 20,000,000 12.5% $ 2,500,000
60% $ 24,000,000 15.5% $ 3,720,000

c.
% Debt EBIT Interest Expense EBT Taxes

0% $ 8,000,000 $ - $ 8,000,000 $ 3,200,000

10% $ 8,000,000 $ 300,000 $ 7,700,000 $ 3,080,000
20% $ 8,000,000 $ 640,000 $ 7,360,000 $ 2,944,000
30% $ 8,000,000 $ 1,080,000 $ 6,920,000 $ 2,768,000
40% $ 8,000,000 $ 1,760,000 $ 6,240,000 $ 2,496,000
50% $ 8,000,000 $ 2,500,000 $ 5,500,000 $ 2,200,000
60% $ 8,000,000 $ 3,720,000 $ 4,280,000 $ 1,712,000

d. Rs (Estimated Po (Estimated Share

% Debt EPS
Required Return) Value)
0% $ 3.00 10.0% $ 30.00
10% $ 3.21 10.3% $ 31.15
20% $ 3.45 10.9% $ 31.65
30% $ 3.71 11.4% $ 32.52
40% $ 3.90 12.6% $ 30.95
 50% $ 4.13 14.8% $ 27.87
60% $ 4.01 17.5% $ 22.93

e. 30% is the best option because it generates the highest Share Value which is $32.52
 Net Income Number of Shares EPS

$ 4,800,000 1,600,000 $ 3.00

$ 4,620,000 1,440,000 $ 3.21
$ 4,416,000 1,280,000 $ 3.45
$ 4,152,000 1,120,000 $ 3.71
$ 3,744,000 960,000 $ 3.90
$ 3,300,000 800,000 $ 4.13
$ 2,568,000 640,000 $ 4.01
P13-27 Integrative—Optimal capital structure Answer:

a.

Sales Probability
$ 600,000 0.3
$ 900,000 0.4 b.
$ 1,200,000 0.3

Capital structure Before-tax cost Required return, c.

debt ratio of debt, rd rs
0% 0.0% 10.0%
15% 8.0% 10.5%
30% 10.0% 11.6%
45% 13.0% 14.0%
60% 17.0% 20.0%

d.
e.
Answer:

Probability of Sales 0.3 0.4

Sales Revenue $ 600,000 $ 900,000
Less : Fixed Operationg Costs $ (300,000) $ (300,000)
Less : Variable Operationg Costs (40% of Sales) $ (240,000) $ (360,000)
EBIT $ 60,000 $ 240,000

Number of Shares
% Debt Total Assets Debt Equity @$25
0% $ 1,000,000 $ - $ 1,000,000 40,000
15% $ 1,000,000 $ 150,000 $ 850,000 34,000
30% $ 1,000,000 $ 300,000 $ 700,000 28,000
45% $ 1,000,000 $ 450,000 $ 550,000 22,000
60% $ 1,000,000 $ 600,000 $ 400,000 16,000

Before-tax Cost of
% Debt Total Debt Debt Interest Expense

0% $ - 0.0% $ -
15% $ 150,000 8.0% $ 12,000
30% $ 300,000 10.0% $ 30,000
45% $ 450,000 13.0% $ 58,500
60% $ 600,000 17.0% $ 102,000

Profitability of EBIT 0.3 with Sales 600.000

% Debt EBIT Interest Expense EBT Taxes
0% $ 60,000 $ - $ 60,000 $ 24,000
15% $ 60,000 $ 12,000 $ 48,000 $ 19,200
30% $ 60,000 $ 30,000 $ 30,000 $ 12,000
45% $ 60,000 $ 58,500 $ 1,500 $ 600
60% $ 60,000 $ 102,000 $ (42,000) $ (16,800)
Profitability of EBIT 0.4 with Sales 900.000
% Debt EBIT Interest Expense EBT Taxes
0% $ 240,000 $ - $ 240,000 $ 96,000
15% $ 240,000 $ 12,000 $ 228,000 $ 91,200
30% $ 240,000 $ 30,000 $ 210,000 $ 84,000
45% $ 240,000 $ 58,500 $ 181,500 $ 72,600
60% $ 240,000 $ 102,000 $ 138,000 $ 55,200
Profitability of EBIT 0.4 with Sales 1.200.000
% Debt EBIT Interest Expense EBT Taxes
0% $ 420,000 $ - $ 420,000 $ 168,000
15% $ 420,000 $ 12,000 $ 408,000 $ 163,200
 30% $ 420,000 $ 30,000 $ 390,000 $ 156,000
45% $ 420,000 $ 58,500 $ 361,500 $ 144,600
60% $ 420,000 $ 102,000 $ 318,000 $ 127,200

% Debt Expected EPS SD of EPS CV of EPS

0% $ 3.60 $ 3.82 $ 1.06
15% $ 4.02 $ 4.49 $ 1.12
30% $ 4.50 $ 5.45 $ 1.21
45% $ 4.95 $ 6.94 $ 1.40 Recommended because it generates
60% $ 5.18 $ 9.55 $ 1.84 >> but otherwise it also has the highest
 0.3 f.
$ 1,200,000 Expected E
$ (300,000) $6.00
$ (480,000)
$5.00 $4.50
$ 420,000
$4.02
$3.60
$4.00

$3.00

$2.00

$1.00

$-
0% 15% 30%

Coeffi cient of Varia

$2.00
$1.80
$1.60
$1.40 $1.21
$1.06
$1.20 $1.12
$1.00
$0.80
Net Income Number of Shares EPS $0.60
$ 36,000 40,000 $ 0.90 $0.40
$ 28,800 34,000 $ 0.85 $0.20
$ 18,000 28,000 $ 0.64 $-
0% 15% 30%
$ 900 22,000 $ 0.04
$ (25,200) 16,000 $ (1.58)
g. Profability
Net Income Number of Shares EPS % Debt
$ 144,000 40,000 $ 3.60 0%
$ 136,800 34,000 $ 4.02 30%
$ 126,000 28,000 $ 4.50 60%
$ 108,900 22,000 $ 4.95
$ 82,800 16,000 $ 5.18 EBIT-EPS Appro
$14.00
Net Income Number of Shares EPS
$12.00
$ 252,000 40,000 $ 6.30
$10.00
$ 244,800 34,000 $ 7.20
$8.00

$6.00

$4.00
 $14.00

$12.00

$10.00

$8.00
$ 234,000 28,000 $ 8.36
$ 216,900 22,000 $ 9.86 $6.00

$ 190,800 16,000 $ 11.93 $4.00

$2.00

$-
$60,000 $240,000
$(2.00)

$(4.00)

mended because it generates the highest return and maximize the EPS, 0% 30%

herwise it also has the highest risk. (High risk high return)
h.
% Debt

0%
15%
30%
45%
60%

i.
Based on findings n part f, Debt 60% is reco
because it has the highest estimated share v
the highest estimated share value and also
 Expected EPS StandarD deviati on of E
6.00 $12.00
$5.18
$4.95
5.00 $4.50 $10.00
$4.02
$3.60
4.00 $8.00 $

3.00 $6.00 $5.45

$4.49
$3.82
2.00 $4.00

1.00 $2.00

$- $-
0% 15% 30% 45% 60% 0% 15% 30% 4

Expected EPS SD of EPS CV o

Coeffi cient of Variati on of EPS
$2.00 $1.84
$1.80 $12.00

$1.60
$1.40 $10.00
$1.40 $1.21
$1.06
$1.20 $1.12 $8.00

$1.00
$6.00
$0.80
$0.60 $4.00

$0.40
$2.00
$0.20
$- $-
0% 15% 30% 45% 60% 0% 15% 30%

0.3 0.4 0.3

$ 60,000 $ 240,000 $ 420,000
$ 0.90 $ 3.60 $ 6.30
$ 0.64 $ 4.50 $ 8.36
$ (1.58) $ 5.18 $ 11.93

EBIT-EPS Approach
$14.00

$12.00

$10.00

$8.00

$6.00

$4.00
$14.00

$12.00

$10.00

$8.00

$6.00

$4.00

$2.00

$-
$60,000 $240,000 $420,000
$(2.00)

$(4.00)

0% 30% 60%

Rs (Estimated Po (Estimated Share

Expected EPS
Required Return) Value)
$ 3.60 10.0% $ 36.00
$ 4.02 10.5% $ 38.32
$ 4.50 11.6% $ 38.79
$ 4.95 14.0% $ 35.36
$ 5.18 20.0% $ 25.88

sed on findings n part f, Debt 60% is recommended because it maximize the EPS. But on findings in part h, Debt 30% is chosen
cause it has the highest estimated share value. Therefore, based on these findings, Debt 30% is recommended because it gene
e highest estimated share value and also has lower risk than debt 60%.
D deviati on of EPS

$9.55

$6.94
$5.45

30% 45% 60%

S SD of EPS CV of EPS

30% 45% 60%

 h, Debt 30% is chosen
mended because it generates