Solutions Manual

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.

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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 market
value of debt is:
P80,000
0.08 = D

P80,000
D = 0.08

= P1,000,000

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Substituting EBIT = P800,000, I = P80,000, and k s = 0.12, the market

value of equity is:
P800,000 − P80,000
S = 0.12

P720,000
= 0.12

= P6,000,00
0

Substituting D = P1,000,000 and S = P6,000,000, the total market value

of the firm is:
V = P1,000,000 + P6,000,000

= P7,000,000

(b) Substituting EBIT = P800,000 and V = P7,000,000, the weighted

average cost of capital is:
P800,000
ka = P7,000,000

= 0.1143 or 11.43%

Problem 2

(a) Substituting kd = 0.08 and I = P200,000 and solving for D, the market
value of debt is:
P200,000
0.08 = D

P200,000
D = 0.08

= P2,500,000

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Substituting EBIT = P800,000, I = P200,000, and k s = 0.125, the market

value of equity is:
P800,000 − P200,000
S = 0.125

P600,000
= 0.125

= P4,800,00
0
Substituting D = P2,500,000 and S = P4,800,000, the total market value
of the firm is:
V = P2,500,000 + P4,800,000

= P7,300,000

(b) Substituting EBIT = P800,000 and V = P7,300,000, the weighted

average cost of capital is:
P800,000
ka = P7,300,000

= 0.1096 or 10.96%

(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
market value of ordinary equity share outstanding is:
P7,000,000 = P2,500,000 + S
S = P7,000,000 − P2,500,000
= P4,500,000

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Substituting EBIT = P800,000, I = P200,000, and S = P4,500,000, the

cost of equity is:
P800,000 − P200,000
ks = P4,500,000

= 0.1333 or 13.33%

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:
P1,500,000
ks =
P10,000,000

= 0.1500 or 15.00%

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.

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Problem 6

(a) The value of Rocky Road Corporation with no leverage is:

Value of the firm (P750,000) (1− 0.34)

with no leverage = 0.15

P495,000
= 0.15

= P3,300,000

(b) 1. The value of Rocky Road Corporation with P1,000,000 in debt is:
Value of the firm
with leverage = P3,300,000 + (0.34) (P1,000,000)

= P3,640,000

2. The total market value with P2,000,000 in debt is:

Value of the firm
with leverage = P3,300,000 + (0.34) (P2,000,000)

= P3,980,000

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
C P40,000,000 + P2,400,000 − P 250,000 = P42,150,000
D P40,000,000 + P3,600,000 − P 800,000 = P42,800,000
E P40,000,000 + P4,200,000 − P2,000,000 = P42,200,000
F P40,000,000 + P5,400,000 − P5,000,000 = P40,400,000

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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:

EPS (debt) = EPS (ordinary equity share)

(EBIT* – P720) (1 − 0.34) – P 0 (EBIT* – P 0) (1 − 0.34) – P 0

500 = 750

0.66 EBIT* – P475.20 0.66 EBIT*

500 = 750

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

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(c) The EPS are calculated as follows:

Plan B:
Plan A: Ordinary
Debt 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:

EPS (debt) = EPS (ordinary equity share)

(EBIT* – P3,200) (1 − 0.34) – P525 (EBIT* – P2,200) (1 − 0.34) – P525

2,000 = 2,500

0.66 EBIT* – P2,112 – P525 0.66 EBIT* – P1,452 – P525

2,000 = 2,500

Cross multiplying:
(2,500) (0.66 EBIT* – P2,637) = (2,000) (0.66 EBIT* – P1,977)
1,650 EBIT* – P6,592,500 = 1,320 EBIT* – 3,954,000
330 EBIT* = P2,638,500
EBIT* = P7,995.455 (in thousands)
or P7,995,455

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(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, ȓ = P9,500,000, and σ = P1,500,000, the z
value is:
z P7,995,455 – P9,500,000
= P1,500,000

– P1,504,545
= P1,500,000

= – 1.00 (rounded)

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 2:
Plan 1: Ordinary
Debt 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.

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