Drill 4: Capital Structure and Leverage

Directions: Write your answers on a piece of paper in good form. Scan or take a picture of the paper and
merge into one PDF. Send your answers via Messenger or gmail on or before May 6, 2020, 12NN.

Problem 1 coupon interest rate 8%; DFL

Brosnan Milling Company is in the process of getting started as going concern. The entity’s potential owners have
calculated that P200,000 is needed to purchase the necessary assets to start with the business. Three alternative
plans for financing the P200,000, as follows:

Debt Equity Common Shares

Outstanding
Plan A 0 P200,000 2,000 shares
Plan B P50,000 P150,000 1,500 shares
Plan C P80,000 P120,000 1,200 shares

Required:
1. Complete the following table considering the following EBIT levels: a. 0, b. P20,000, c. P40,000, d. P60,000,
e. P80,000.
PLAN A
EBIT Interest EBT Taxes Net Income Earnings Per Degree of
Expense to Common Share Financial
Leverage
0 0 0 0 0 0 0
P20,000 0 20,000 10,000 10,000 5
P40,000 0 40,000 20,000 20,000 10
P60,000 0 60,000 30,000 30,000 15
P80,000 0 80,000 40,000 40,000
PLAN B
EBIT Interest EBT Taxes Net Income Earnings Per Degree of
Expense to Common Share Operating
Leverage
0 0
P20,000
P40,000
P60,000
P80,000
PLAN C
EBIT Interest EBT Taxes Net Income Earnings Per Degree of
Expense to Common Share Operating
Leverage
0 0
P20,000
P40,000
P60,000
P80,000

2. Examine the rate of changes in the earnings per share among the different level of leverages. How does
financial leverage impact the performance of firms? The firm’s share price?
3. When is most advisable for firms to resort to leveraged financing?

Problem 2
Aaron Athletics is trying to determine its optimal capital structure. The company’s capital structure consists of debt
and common stock. In order to estimate the cost of debt, the company has produced the following table:

Debt-to-total- Equity-to-total- Debt-to-equity Bond Before-tax

assets ratio (wd) assets ratio (wc) ratio (D/E) rating cost of debt

0.10 0.90 0.10/0.90 = 0.11 AA 7.0%

0.20 0.80 0.20/0.80 = 0.25 A 7.2
0.30 0.70 0.30/0.70 = 0.43 A 8.0
0.40 0.60 0.40/0.60 = 0.67 BB 8.8
0.50 0.50 0.50/0.50 = 1.00 B 9.6

The company’s tax rate, T, is 40 percent.

The company uses the CAPM to estimate its cost of common equity, k s. The risk-free rate is 5 percent and the
market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (Its “unlevered
beta,” bU, equals 1.0.)

1. On the basis of this information, what is the company’s optimal capital structure, and what is the firm’s
weighted average cost of capital (WACC) at this optimal capital structure?

Problem 3

Currently, the Fotopoulos Corporation’s balance sheet is as follows:

Assets P5 billion Debt P1 billion

Common equity 4 billion
Total assets P5 billion Total debt & common equity P5 billion

The book value of the company (both debt and common equity) equals its market value (both debt and common
equity). Furthermore, the company has determined the following information:

 The company estimates that its before-tax cost of debt is 7.5 percent.
 The company estimates that its levered beta is 1.1.
 The risk-free rate is 5 percent.
 The market risk premium, kM – kRF, is 6 percent.
 The company’s tax rate is 40 percent.

In addition, the Fotopoulos Corporation is considering a recapitalization. The proposed plan is to issue $1
billion worth of debt and to use the money to repurchase $1 billion worth of common stock. As a result of this
recapitalization, the firm’s size will not change.

2. What is Fotopoulos’ current WACC (before the proposed recapitalization)?

3. What is Fotopoulos’ current unlevered beta (before the proposed recapitalization)?

4. What will be the company’s new cost of common equity if it proceeds with the recapitalization? (Hint: Be
sure that the beta you use is carried out to 4 decimal places)

Problem 3