Chapter 13

Long-Term Financial Decisions

 Answers to Review Questions

13-1 Leverage refers to the use of fixed expenses to magnify shareholder returns. Operating leverage refers to the use
of fixed operating costs to magnify the impact of changes in sales revenue on earnings before interest and taxes
(EBIT). Financial leverage refers to the use of fixed financial costs (like interest on debt) to magnify the impact
of changes in EBIT on earnings available to common shareholders and earnings per share. Total leverage refers to
the overall sensitivity of common earnings to changes in sales; it reflects the combined impact of operating and
financial leverage.

13-2 The firm’s operating breakeven point is the level of sales at which all fixed and variable operating costs are
covered, i.e., EBIT equals zero. An increase (decrease) in fixed operating costs and variable operating costs will
increase (decrease) the operating breakeven point. An increase (decrease) in the selling price per unit will
decrease (increase) the operating breakeven point.

13-3 Operating leverage is the ability to use fixed operating costs to magnify the effects of changes in sales on
earnings before interest and taxes. Operating leverage results from the existence of fixed operating costs in the
firm’s overall cost structure. The degree of operating leverage (DOL) is measured by dividing the percent change
in EBIT by the percent change in sales. It can also be calculated for a base sales level using the following
equation:

Where:
Q  unit sales VC  variable costs per unit
P  sales price per unit FC  fixed costs per period

13-4 Financial leverage refers to the use of fixed financial costs to magnify the effects of changes in EBIT on earnings and
earnings per share (EPS); it arises when a firm relies on funding sources with fixed costs such as interest on debt and
dividends on preferred stock. The degree of financial leverage (DFL) can be measured in two ways:

(i)

(ii)
Where:
EPS  earnings per share I  interest on debt
EBIT  earnings before interest and taxes PD  dividends on preferred stock

13-5 The total leverage of the firm is the combined effect of fixed costs (operating and financial) on EPS; it reflects
both operating and financial leverage. Increases in either type of leverage will increase the total risk of the firm.
 Both types of leverage complement each other in the sense that their effects are multiplicative, not additive. This
means the overall effect on firm risk and return can be quite large because the interaction of operating and financial
leverage more than proportionately magnifies the impact of changes in sales on EPS.

13-6 A firm’s capital structure is the mix of long-term debt and equity it utilizes. The key differences between debt
and equity capital are summarized:
Characteristic Debt Equity
Voice in management* No Yes
Claims on income and assets Senior to equity Subordinate to debt
Maturity Stated None
Tax treatment Interest deduction No deduction
*
In default, debt holders and preferred stockholders may receive a voice in management;
otherwise, only common stockholders have voting rights.

The degree of financial leverage in the firm’s capital structure can be measured directly with the debt ratio and the
debt-equity ratios or indirectly with the times interest earned and fixed-payment coverage ratios. Higher direct
ratios indicate a greater level of financial leverage. If coverage ratios are low, the firm is less able to meet fixed
payments and will generally have high financial leverage.

13-7 In general, non-U.S. companies rely much more on debt than U.S. corporations. In large part, this difference
reflects the relative sophistication of U.S. capital markets, which offer a large menu of financing options. Also,
large commercial banks take an active role in financing foreign corporations. Finally, share ownership for foreign
companies is more concentrated, which reduces potential agency problems, thereby permitting a greater use of
leverage.
Apart from differences in leverage, the general tendencies in capital structure for U.S. firms carry over to non-
U.S. firms. For example, debt ratios within foreign-industry groupings generally follow similar patterns, as they
do in the United States, and large multinational companies (MNCs) headquartered outside of the United States
share more similarities with other MNCs than with smaller firms based in their home country. In recent years,
foreign firms have moved away from bank financing, leading to capital structures more like that of U.S.
corporations.

13-8 The tax deductibility of interest is the major benefit of debt finance. In effect, the government subsidizes debt
through the tax deduction— the deducting interest expense reduces the taxes paid on profits, thereby allowing
investors to enjoy higher earnings. Note: the recently passed Tax Cuts and Jobs Act reduced the tax benefit of
debt financing by cutting the corporate tax rate to 21%

13-9 Business risk refers to fluctuations of the firm’s cash flows not traceable to fixed-cost financing. Business risk
reflects (i) fixed operating costs (operating leverage), revenue stability, and cost stability. Revenue stability refers
to the variability of the firm’s sales revenues, which in turn depends on demand for the firm’s product. Cost
stability refers to the relative predictability of input prices such as labor and materials. The more stable a firm’s
revenues and costs, the lower its business risk. Business risk influences capital structure— firms with more
business risk tend to rely less on debt finance. Financial risk refers to fluctuations in cash flows to the firm’s
shareholders arising from greater reliance on debt and other fixed-cost forms of financing. The more a firm relies
on fixed-cost financing (debt, leases, and preferred stock), the greater its financial leverage and financial risk.
13-10 An agency problem arises in borrowing because lenders provide funds based on their expectations about firm risk.
But firm managers can increase shareholder wealth by increasing risk after loan terms have been set. Lenders
protect themselves with a combination of explicit restrictions on firm actions (covenants) to limit
 business/financial risk and careful monitoring to ensure compliance. Covenants may include minimum levels of
net working capital as well as restrictions on asset acquisitions, additional debt (through minimum coverage
ratios), executive salaries, and dividend payments. The cost to the firm of complying with covenants is an agency
cost. For bearing these costs, however, the firm can enjoy lower interest expense and, perhaps, greater access to
debt finance.

13-11 Asymmetric information results when a firm’s managers have more information about operations and future
prospects than investors. This information edge could cause financial managers to raise funds using a pecking
order (a hierarchy of financing beginning with retained earnings, followed by debt, and finally, equity) rather than
maintaining a target capital structure.
Because of management’s asymmetric information, the firm’s financing decisions can give signals to investors
reflecting management’s view of the stock value. The use of debt sends a positive signal that management
believes its stock is undervalued. Conversely, issuing new stock may be interpreted as a negative signal that
management believes the stock is overvalued. This leads to a decline in share price, making new equity financing
very costly.

13-12 As financial leverage increases, both the cost of debt and the cost of equity increase, with equity rising at a faster
rate. As reliance on debt rises, the overall cost of capital first decreases to a minimum, and then begins to rise. The
optimal capital structure is associated with the minimum cost of capital. This capital structure allows
management to invest in the larger number of profitable projects, thereby maximizing shareholder wealth.

13-13 The EBIT-EPS approach shows how different capital structures affect EPS over a range of EBIT. The EBIT-EPS
approach involves selecting the capital structure providing maximum EPS, which admittedly may or may not be
consistent with the maximization of share price. It is used to select the best of a number of possible capital
structures, rather than to determine an “optimal capital structure.” The financial breakeven point is the level of
EBIT at which the firm’s EPS would equal zero. The financial breakeven point can be determined with the
before-tax cost of interest and level of preferred dividends. If I  interest, PD  preferred dividends, and t  the
tax rate, the financial breakeven point is given by: I + [PD ÷ (1 – Tax Rate)]. The following graph illustrates this
financial breakeven point.

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13-14 It is unlikely that attempts to maximize value would produce the same capital structure as attempts to maximize
earnings per share (EPS). In general, the capital structure that maximizes value will feature less debt than the
structure that maximizes EPS (because EPS maximization neglects risk).

13-15 The firm should find the capital structure that balances risk and return to maximize share value. This requires
estimating EPS and required rates of return for different levels of debt then choosing the debt-equity mix that
produces the highest share price. In addition to quantitative considerations, the firm should take into account
factors related to business risk, agency costs, and asymmetric information. These include (1) revenue stability, (2)
cash flow, (3) contractual obligations, (4) management preferences, (5) control, (6) external risk assessment, and
(7) timing.

Suggested Answer to Focus on Practice Box: Qualcomm’s Leverage:

Operating leverage exists when a firm uses fixed operating costs to magnify the impact of changes in sales on
earnings before interest and taxes (EBIT). The pros and cons stem from the impact of leverage on EBIT. The
upside: When a firm has fixed operating costs, an increase in sales will produce a greater-than-proportional
increase in EBIT. The downside: Operating leverage also magnifies the impact of a decline in sales on EBIT. In
FY 2011, for example, Qualcomm enjoyed a 32.4% increase in sales over the previous year, and the 1.5 degree of
operating leverage (DOL) magnified this sales increase into a 48.6% jump in EBIT. In FY 2016, in contrast, the
1.9 DOL turned a 6.8% fall off in sales caused EBIT to tumble 13.1%.

 Solutions to Problems
P13-1 Breakeven point: Algebraic (LG1; Basic)
Q = Fixed Cost ÷ (Price – Variable Cost) = $21,000 ÷ ($1,250 ‒ $750) = $42.

P13-2 Breakeven comparisons: Algebraic (LG 1; Basic)

a. Q = Fixed Cost (Price – Variable Costs)
÷

Firm Jaipur Rugs: Q = INR500,000 ÷ (INR1,500 – INR800) = 714 units

Firm FabIndia: Q = INR640,000 ÷ (INR1,900 – INR950) = 674 units
Firm Ashok Carpets: Q = INR700,000 ÷ (INR2,150 – INR1,000) = 609 units
b. From least risky to most risky: Ashok Carpets, then FabIndia, and Jaipur Rugs. It is important to recognize
that operating leverage is only one measure of risk.

P13-3 Breakeven point: Algebraic and graphical (LG 1; Intermediate)

a. Q  Fixed Cost ÷ (Price – Variable Cost)  $473,000  ($129  $86)  11,000 units
P13-4 Breakeven analysis (LG 1; Intermediate)
a. Let QBE = breakeven level of unit sales, FC = fixed cost, P = price, and VC = variable cost per unit. Q BE = FC
÷ (P – VC) = 4,000 ÷ ($24 − $14) = 400 canvasses.
b. Let FC = fixed costs, Q = unit sales, and VC = variable cost. Then,
Total operating costs  FC  (Q  VC)  $4,000  (400  $14)  $9,600.
c. Sales of 420 canvasses per month exceed the breakeven level of sales by 20 canvasses. So, Anke will be able
to make a profit.
d. Let EBIT  earnings before interest and taxes, P = unit price, Q = unit sales, FC = fixed cost, and VC =
variable cost per unit. So, EBIT = (P  Q)  FC  (VC  Q):
EBIT  ($24  420) − $4,000 − ($14  420) = $200

P13-5 Personal finance: Breakeven analysis (LG 1; Easy)

a. Breakeven point in months  fixed cost ÷ (monthly benefit – monthly variable costs)
$500  ($35  $20)  $500  $15  33.3 months.
b. Yes, Paul should install the emergency response system. It will pay for itself in 33.3 months, which is less
than the 36 months he plans to own the car.

P13-6 Breakeven point: Changing costs/revenues (LG 1; Intermediate)

Let QBE = breakeven level of unit sales, FC = fixed cost, P = price, and VC = variable cost per unit.
a. QBE  FC  (P  VC)  €1,050,000  (€350  €200)  7,000 rugs
b. QBE  €1,300,000  (€350  €200)  8,667 rugs
c. QBE  €1,050,000  (€320  €200) 8,750 rugs
d. QBE  €1,050,000  (€350  €220)8,077 rugs
e. The breakeven level of unit sales is directly related to fixed and variable costs and inversely related to selling
price.

P13-7 Breakeven analysis (LG 1; Challenge)

Let Q = unit sales, FC = fixed cost, P = price, and VC = variable cost per unit.
a. QBreakeven = FC  (P  VC) = €700 ÷ (€4 − €1.5) = 280 units.
b. Sales €2,000
Less:
Fixed costs 700
Variable costs ($6  1,500) 750
Total cost €1,450
= Earnings before interest and taxes (EBIT)€ 550
c. Sales €2,500
Less:

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 Fixed costs 700
Variable costs ($6  1,500) 750
Total cost €1,450
= EBIT €1,050
d. EBIT = Sales revenue – Total cost (= Fixed cost + Variable cost) = (P Q) – FC – (Q VC)
Given P = €4, FC = €700, VC = €1.50 per unit, and EBIT = €1,200, solve for Q.
1,200 = (€4 × Q) – €700 – (€1.50 × Q) → 1,520 = €2 × Q = 760 units.
e. One alternative is to price the units differently based on variable cost. Those more costly to produce will
have higher prices than the less expensive production models. If Antonio and Giancarlo want to maintain the
same price for all units, they may need to reduce the selection from the 20 types currently available to a
smaller number that includes only those with an average variable cost below $2.6 ($4 – $700/500 units).

P13-8 EBIT sensitivity (LG 2; Intermediate)

a. and b.
10,000 Units 12,000 Units 14,000 Units
Sales $280,000 $336,000 $392,000
Less: Variable costs 180,000 216,000 252,000
Less: Fixed costs 23,000 23,000 23,000
EBIT $77,000 $97,000 $117,000
c.
Unit Sales 10,000 12,000 14,000
% ∆ in unit sales (10,000  12,000)  12,000 0 (14,000  12,000)  12,000
 16.67%  16.67%

% ∆ in EBIT (77,000  97,000)  97,000 0 (117,000  97,000)  97,000

 20.62%  %
d. A given percentage change in sales produces a larger percentage change in EBIT.

P13-9 Degree of operating leverage (DOL) (LG 2; Intermediate)

a. Let QBE = breakeven level of unit sales, FC = fixed cost, P = price, and VC = variable cost per unit.
QBEFC  (P VC) = $3,825  ($24.50 $9.50) = 255 flower arrangements.
b.
260 Units 300 Units 340 Units
Sales $6,370 $7,350 $8,330
Less: Variable costs 2,470 2,850 3,230
Less: Fixed costs 3,825 3,825 3,825
EBIT $ 75 $675 $1,275
c.
∆in unit sales 40 0 40
% ∆in sales 40  300 13.33% 0 40  300 13.33%
∆ in EBIT $600 0 $600
 % ∆in EBIT $600  675 = 88.89% 0 $600  675 = 88.89%
d.

88.89 13.33  6.67 88.89  13.33  6.67

P13-10 Degree of operating leverage (DOL): Graphical (LG 2; Intermediate)

Let Q = unit sales, P = unit price, VC = variable costs, and FC = fixed costs.
a. Breakeven sales, QBE = FC ÷ (P – VC) = €850,000 ÷ (€550 – €350) = 4,250
b. Degree of operating leverage at base sales level, Q, is given by:

DOL ¿ [3,500 ×(€ 550 – € 350)]/[3,500 ×(€ 550−€ 350)] – € 850,000=−4.67

DOL ¿ [ 4,000×(€ 550 – € 350)]/[4,000 ×(€ 550−€ 350)]−€ 850,000=−16.00
DOL ¿ [ 4,500×(€ 550 – € 350)]/[4,500 ×(€ 550−€ 350)]−€ 850,000=18.00
DOL ¿ [5,000 ×(€ 550 – € 350)]/[5,000 ×(€ 550−€ 350)]−€ 850,000=6.67

[ 4,250× ( € 550 – € 350 ) ]

d. DOL ¿ =∞
[ 4,250 × ( € 550−€ 350 ) ]−€ 850,000
At the operating breakeven point, the DOL is infinite.

e. DOL decreases as the firm expands beyond the operating breakeven point.

P13-11 EPS calculations (LG 2; Intermediate)

a. Common earnings = EBIT – Interest – Taxes – Dividends on preferred stock
= (EBIT – Interest) × (1 – Tax rate) – Preferred dividends
= ($130,000 – $7,000)×(1–0.4) – $22,500 = $51,300
Earnings per share (EPS) = Common earnings ÷ Common shares outstanding = 51,300 ÷ 6,000 = $8.55

b. Common earnings = EBIT – Interest – Taxes – Dividends on preferred stock

= (EBIT – Interest) × (1 – Tax rate) – Preferred dividends
= ($95,000 – $7,000)×(1–0.4) – $22,500 = $30,300
Earnings per share (EPS) = Common earnings ÷ Common shares outstanding = 30,300 ÷ 6,000 = $5.05

c. Common earnings = EBIT – Interest – Taxes – Dividends on preferred stock

= (EBIT – Interest) × (1 – Tax rate) – Preferred dividends
= ($73,800 – $7,000)×(1–0.4) – $22,500 = $17,580
Earnings per share (EPS) = Common earnings ÷ Common shares outstanding = 17,580 ÷ 6,000 = $2.93

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 P13-12 Degree of financial leverage (LG 2; Intermediate)
a.
EBIT $75,000 $99,000
Less: Interest 22,500 22,500
Net profits before taxes $52,500 $76,500
Less: Taxes (40%) 21,000 30,600
Net profit after taxes $31,500 $45,900
EPS (3,500 shares) $9.00 $13.11

b. Degree of financial leverage is given by:

where:
I = interest expense
PD = preferred stock dividends
T = tax rate

c. For every 1% change in EBIT, EPS will change 1.43 in the same direction.

P13-13 Personal finance: Financial leverage (LG 2; Challenge)

a.
Current DFL Initial Values Future Value %∆
Available for making loan payment $1,950 $2,340 20.0%
Less: Loan payments $ 800 $ 800 0.0%
Available after loan payments $1,150 $1,540 34.0%
DFL = 34% ÷ 20%  1.70
Proposed DFL Initial Values Future Value %∆
Available for making loan payment $1,950 $2,340 20.0%
Less: Loan payments $1,800 $1,800 0.0%
Available after loan payments $ 150 $ 540 260.0%
DFL = 260.0% ÷ 20%  13.00
b. and c.
The amount Margaret will have available after loan payments with her current debt changes by 1.7% for every 1%
change in the amount she will have available for making the loan payment. This is less responsive and, therefore, less
risky than the 13% change in the amount available after making loan payments with the proposed $1,000 in monthly
rent payments. Although it appears that Margaret can afford the additional rent payments, Margaret must decide if,
given the variability of her income, she would be comfortable with the increased financial leverage and risk.
P13-14 DFL and graphic display of financing plans (LG 2, 5; Challenge)
a. Degree of financial leverage (DFL) is given by:
where:
EBIT = earnings before interest and
taxes
I = interest expense
PD = dividends on preferred stock
= tax rate.

c.
d. See graph, which is based on the following equation and data points:
Financing EBIT EPS
Original $67,500
financing
plan
$17,500

Revised $67,500
financing
plan $17,500

e. The lines representing the two financing plans are parallel because the number of shares of common
stock outstanding is the same in each case. The financing plan, including the preferred stock, leads to a
higher financial breakeven point and lower EPS at any EBIT level.

P13-15 Integrative: Multiple leverage measures (LG 1, 2; Intermediate)

Let Q = unit sales, P = unit price, VC = variable costs, and FC = fixed costs.
a. Breakeven sales, QBE = FC ÷ (P – VC) = 28,000 ÷ (26 – 16) = 2,800 teddy bears
b. Degree of operating leverage is given by:

[350,000($ 26 ‒ $ 16)]
¿ =1.01
[350,000($ 26 ‒ $ 16)‒ $ 28,000 ]

c. Earnings before interest and taxes (EBIT)  (P  Q)  FC  (Q  VC)

EBIT  ($26  350,000)  [$28,000  (350,000  $16)] = $3,472,000
Degree of financial leverage (DFL) is given by:

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 where:
I = interest expense
PD = dividends on preferred stock
T = tax rate
$ 3,472,000
DFL= =1.003
[$ 3,472,000 ‒ $ 4,500 ‒
(
$ 3,000
(1−0.4)
]
)
d. DTL  DOL  DFL = DTL  1.01  1.003 = 1.01. The two formulas give the same result.

P13-16 Integrative: Leverage and risk (LG 2; Intermediate)

a. Let Q = unit sales, P = unit price, VC = variable costs, and FC = fixed costs.

So,
Now,

where:
EBIT = earnings before interest and taxes PD = dividends on preferred stock
I = interest expense T = tax rate
There are no preferred dividends, so:

Finally, degree of total leverage (DTL) is given by DOL × DFL, so

b.

c. Firm R has less operating (business) risk but more financial risk than Firm W.
 d. Two firms with differing operating and financial structures may be equally leveraged. Because total
leverage is the product of operating and financial leverage, each firm may structure itself differently and
still have the same amount of total risk.
P13-17 Integrative—multiple leverage measures and prediction (LG 1, 2; Challenge)
a. Let Q = unit sales, P = unit price, VC = variable costs, and FC = fixed costs.
QBreakeven  FC  (P  VC) = L2,000,000÷(L60 – L400) = 10,000 units of flu medicine
b. Sales (L600  11,000) L6,600,000
Less:
Fixed costs 2,000,000
Variable costs (L400  11,000) 4,400,000
= EBIT 200,000
Less interest expense 150,000
= EBT 50,000
Less taxes (15%) 7,500
= Net profits L 42,500
Earnings available for common stockholders (or common earnings)
= Net profits – Preferred dividends = L42,500 – L40,000 = L2,500.

c.
[L 11,000×(L 600−L 400)]
So, DOL= =11.0
[L 11,000×(L 600−L 400)]
d. Degree of financial leverage (DFL) is given by:
where:
I = interest expense
PD = dividends on preferred stock
T = tax rate
L200,000
DFL= =68.0
So,
[L 200,000 ‒ L 150,000 ‒
(
L 40,000
(1−0.85)
]
)
where:
EBIT = earnings before interest and taxes PD = dividends on preferred stock
I = interest expense T = taxes
e. Degree of total leverage (DTL)  DOL  DFL  11  68.00 748 (or 74,800%).
f. DOL = %∆ EBIT ÷ % ∆ sales, so %∆ EBIT  % ∆ sales  DOL.
% ∆ sales = Extra sales in coming year ÷ Current unit sales = 5,500 ÷ 11,000 = 50%
So, % ∆ in EBIT  50%  11  550%. And New EBIT  Old EBIT + (Old EBIT % ∆ in EBIT),
so New EBIT = L200,000  (L200,000  550%)  $1,300,000.

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 Now, DTL = % ∆ EPS ÷ % ∆ in sales = % ∆ common earnings ÷ % ∆ in sales, because outstanding
shares did not change. So, % ∆ common earnings = % ∆ sales  DTL = 50%  74,800%  37,400%.
And, new common earnings
= Old common earnings + (Old common earnings % ∆ common earnings)
= L2,500  (L2,500  37,400%)  L937,500.
P13-18 Personal finance: Capital structures (LG 3; Intermediate)
a. Monthly mortgage payment ÷ Monthly gross income = L34,000 ÷ L120,000 = 28.33%
Altin’s ratio is more than the bank’s maximum of 25%.
b. Total monthly installment payment ÷ Monthly gross income = (L15,000 + L34,000) ÷ L120,000 = 40.8%.
c. Altin’s ratios are more than the bank maximums, so his loan application should not be approved.

P13-19 Various capital structures (LG 3; Basic)

Debt Ratio Debt Equity

10% $150,000 $1,350,000
20% $300,000 $1,200,000
30% $450,000 $1,050,000
40% $600,000 $900,000
50% $750,000 $750,000
60% $900,000 $600,000
90% $1,350,000 $150,000
Theoretically, the debt ratio cannot exceed 100%. Practically, few creditors would extend loans to
companies with exceedingly high debt ratios (70%).

P13-20 Debt and financial risk (LG 3; Challenge)

a. EBIT Calculation (000):
Probability 0.25 0.50 0.25
Sales $12,000,000 $15,500,000 $18,300,000
Less: Variable costs (70%) 9,000,000 11,625,000 13,725,000
Less: Fixed costs 1,500,000 1,500,000 1,500,000
EBIT $ 1,500,000 $ 2,375,000 $ 3,075,000
Less: Interest 135,000 135,000 135,000
Earnings before taxes $ 1,365,000 $ 2,240,000 $ 2,940,000
Less: Taxes 327,600 537,600 705,600
Earnings after taxes $1,037,400 $1,702,400 $2,234,400
b. EPS:
Earnings after taxes € 1,037,400 €1,702,400 €2,234,400
Number of shares 25,500 25,500 25,500
EPS € 40.68 €66.76 € 87.62

 (€40.68×0.25)+(€66.76×0.50)+(€87.62×0.25)
 
 √
σ EPS= [ ( € 40.68−€ 66.76 ) × 0.25 ] +[ ( € 66.76−€ 66.76 ) ×0.50 ]+[ ( € 87.62−€ 66.76 ) × 0.25]
2 2 2

σ EPS= √(−€ 680.16 × 0.25)+ 0+(€ 435.13× 0.25)

σ EPS= √−€ 170.04+ € 108.78= √−€ 61.26=7.83
σ EPS 7.83
C V EPS = = =0.12
Expected EPS 65.46
c.
EBIT * €1,500,000 €2,375,000 €3,075,000
Less: Interest 0 0 0
Net profit before taxes €1,500,000 €2,375,000 €3,075,000
Less: Taxes 360,000 570,000 738,000
Net profits after taxes €1,140,000 €1,805,000 €2,337,000
EPS (15,000 shares) € 38.00 € 60.17 € 77.90
*
From part a

Expected EPS  (€38×0.25)+(€60.17×0.50)+(€77.90×0.25)=€59.06

√
σ EPS= [ ( € 38−€ 60.17 ) ×0.25 ]+[ ( € 60.17−€ 60.17 ) ×0.50]+[ ( € 77.90−€ 60.17 ) × 0.25]
2 2 2

σ EPS= √ (−€ 22.17 × 0.25)+ 0+( € 17.73 ×0.25)

σ EPS = √−€ 5.54+ € 4.43=√−€ 1.11=1.05
σ EPS 1.05
C V EPS = = =0.02
Expected EPS 59.06

d. Summary statistics:
With Debt All Equity Including debt in Barrila’s capital structure
Expected EPS €65.46 €59.06 produces a higher expected EPS, a higher
EPS €16.65 €14.15 standard deviation, and a higher coefficient of
variation than the all-equity structure. Eliminating
CVEPS 0.25 0.24 debt from the firm’s capital structure reduces
financial risk (as measured by the coefficient of
variation for EPS).

P13-21 EPS and optimal debt ratio (LG 4; Intermediate)

a.

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 Maximum EPS appears to be at 60% debt
ratio, with $3.95 per share earnings.

b.
Debt Ratio CV
0% 0.5
20 0.6
40 0.8
60 1.0
80 1.5

P13-22 EBIT-EPS and capital structure LG 5; Intermediate

a. Using €30,000 and €50,000 EBIT:
Structure A Structure B
EBIT €30,000 €50,000 €30,000 €50,000
Less: Interest 12,000 12,000 7,500 7,500
Net profits before taxes €18,000 €38,000 €22,500 €42,500
Less: Taxes 4,320 9,120 5,400 10,200
Net profit after taxes €13,680 €28,880 €17,100 €32,300
 Earnings available for €13,680 €28,880 €17,100 €32,300
common
shareholders
EPS (8,000 shares) € 1.710 € 3.610
EPS (10,000 shares) € 1.71 € 3.23
Financial breakeven points:
Structure A Structure B
€12,000 €7,500
b.

c. If EBIT is expected to fall below €30,000, Structure B is preferred. If EBIT is expected to top €30,000,
Structure A is preferred.
d. Structure B offers less risk and lower returns as EBIT increases; structure A has more risk because of
its higher financial breakeven point. The steeper slope of the line for Structure A also indicates greater
financial leverage.
e. If EBIT is expected to be €55,000, Structure A should be recommended because changes in EPS are
much greater for given values of EBIT.

P13-23 EBIT-EPS and preferred stock (LG 5: Intermediate)

a.
Structure A Structure B
EBIT €30,000 €40,000 €30,000 €40,000
Less: Interest 10,000 10,000 2,500 2,500
Net profits before taxes €20,000 €30,000 €27,500 €37,500
Less: Taxes 4,800 7,200 6,600 9,000
Net profit after taxes €15,200 €22,800 €20,900 €28,500
Less: Preferred stock dividend 1,200 1,200 2,400 2,400
Earnings available for €14,000 €21,600 €18,500 €26,100
common shareholders
EPS (5,000 shares) € 2.800 € 4.320
EPS (10,000 shares) € 1.85 € 2.61

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 b.

c. Structure A has greater financial leverage, hence greater financial risk.

d. If EBIT is expected to be below €17,000, Structure B is preferred. If EBIT is expected to be above
€17,000, Structure A is preferred.
e. If EBIT is expected to be €42,000, Structure A is recommended since changes in EPS are much greater
for given values of EBIT.
P13-24 Integrative: Optimal capital structure (LG 3, 4, 6; Intermediate)
a.
Debt Ratio 0% 15% 30% 45% 60%
EBIT $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000
Less: Interest 0 120,000 270,000 540,000 900,000
EBT $2,000,000 $1,880,000 1,730,000 $1,460,000 $1,100,000
 Taxes: 40% of EBT 800,000 752,000 692,000 584,000 440,000
Net profit $1,200,000 $1,128,000 $1,038,000 $ 876,000 $ 660,000
Less: Preferred dividends 200,000 200,000 200,000 200,000 200,000
Profits available to
 common stock $1,000,000 $ 928,000 $ 838,000 $ 676,000 $ 460,000
No. of shares outstanding 200,000 170,000 140,000 110,000 80,000
EPS $ 5.00 $ 5.46 $ 5.99 $ 6.15 $ 5.75
b. Estimated share price (Po) = EPS ÷ required return on common stock (rs)
Debt: 0% Debt: 15% Debt: 60%

Debt: 30% Debt: 45%

c. The optimal capital structure would be 30% debt and 70% equity because this debt/equity mix
maximizes the price of the common stock.
P13-25 Integrative: Optimal capital structures (LG 3, 4, 6; Challenge)
a. 0% debt ratio – baseline:
Probability (p)
p1 = 0.25 p2 = 0.50 P3 =0.25
Sales €355,000 €500,000 €625,000
Less: Variable costs (50% of sales) 177,500 250,000 312,500
Less: Fixed costs 170,000 170,000 170,000
EBIT € 7,500 € 80,000 €142,500
Less: Interest 0 0 0
Earnings before taxes € 7,500 € 80,000 €142,500
Less: Taxes (29% of before-tax earnings) 2,175 23,200 41,325
Earnings after taxes € 5,325 € 56,800 €101,175
EPS (After-tax earnings ÷ 20,000 shares) € 0.27 € 2.84 € 5.06
Note: Total capital with 100% equity = €400,000 (20,000 shares  €20 book value)

Summary statistics – EPS (0% debt):

Expected (EPS) = (p1×EPS1) + (p2×EPS2) + (p3×EPS3)
= (0.25 ×€0.27)+ (0.50 ×€2.84)+ (0.25 ×€5.06) = €2.75
Standard deviation:
Because all outcomes and probabilities are known, standard deviation (EPS) is given by:
σEPS = [p1×(EPS1 – Expected EPS)2 + p2×(EPS2 – Expected EPS)2 +
p3×(EPS3 – Expected EPS)2](1/2)
σ EPS =[0.25× ( 0.27−2.75 )2+ 0.50 × ( 2.84−2.75 )2 +0.25 × ( 5.06−2.75 )2 ]¿¿¿
σ EPS=(1.54+0.00+ 1.33)¿ ¿¿
Coefficient of variation ( EPS )=Standard deviation ( EPS)÷ Expected EPS
¿ € 1.69÷ € 2.75=€ 0.6145
***

20% debt ratio:

Amount of debt  20%×€400,000=€80,000
Amount of equity  80%  €400,000 €320,000
Number of shares  €320,000  €20 book value 16,000 shares

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 Probability (p)
p1 = 0.25 p2 = 0.50 P3 =0.25
Sales €355,000 €500,000 €625,000
Less: Variable costs (50% of sales) 177,500 250,000 312,500
Less: Fixed costs 170,000 170,000 170,000
Sales € 7,500 € 80,000 €142,500
Less: Interest 80,000 8,000 8,000
Earnings before taxes € (500) €72,000 €134,500
Less: Taxes (29% of before-tax earnings) (145) 20,800 39,005
Earnings after taxes € (645) €51,120 € 95,495
EPS (After-tax earnings ÷ 20,000 shares) € (0.04) € 3.20 € 5.97
Summary statistics – EPS (20% debt):
Expected (EPS) = €3.08
Standard deviation, σEPS = €2.13
Coefficient of variation (EPS) =€2.13 ÷ €3.08 = €0.6916

***
30% debt ratio:
Amount of debt  30% × €400,000 = €80,000
Number of shares  €280,000 ÷ €20 book value = 14,000 shares
Probability (p)
p1 = 0.25 p2 = 0.50 P3 =0.25
Sales €355,000 €500,000 €625,000
Less: Variable costs (50% of sales) 177,500 250,000 312,500
Less: Fixed costs 170,000 170,000 170,000
Sales € 7,500 € 80,000 €142,500
Less: Interest 14,400 14,400 14,400
Earnings before taxes € (6,900) €65,600 €128,100
Less: Taxes (29% of before-tax earnings) (2,001) 19,024 37,149
Earnings after taxes € (8,901) €46,576 € 90,951
EPS (After-tax earnings ÷ 14,000 shares) € (0.64) € 3.33 € 6.50

Summary statistics – EPS (40% debt):

Expected (EPS) = €3.13
Standard deviation, σEPS = €2.53
Coefficient of variation (EPS) = €2.53 ÷€3.13 =€0.8083

***
40% debt ratio:
Amount of debt  40%  €400,000  €160,000
Number of shares  €240,000 equity  €20 book value  12,000 shares
 Probability (p)
p1 = 0.25 p2 = 0.50 P3 =0.25
Sales €355,000 €500,000 €625,000
Less: Variable costs (50% of sales) 177,500 250,000 312,500
Less: Fixed costs 170,000 170,000 170,000
Sales € 7,500 € 80,000 €142,500
Less: Interest 22,400 22,400 22,400
Earnings before taxes €(14,900) €57,600 €120,100
Less: Taxes (29% of before-tax earnings) (4,321) 16,704 34,829
Earnings after taxes €(19,221) €46,576 € 85,271
EPS (After-tax earnings ÷ 12,000 shares) € (1.60) € 3.41 € 7.11

Summary statistics – EPS (0% debt):

Expected (EPS) = €3.08
Standard deviation, σEPS = €3.10
Coefficient of variation (EPS) = €3.10 ÷ €3.08 = €1.0064

***
50% debt ratio:
Amount of debt  50%  €400,000  €200,000
Number of shares  €200,000 equity  €20 book value  10,000 shares
Probability (p)
p1 = 0.25 p2 = 0.50 P3 =0.25
Sales €355,000 €500,000 €625,000
Less: Variable costs (50% of sales) 177,500 250,000 312,500
Less: Fixed costs 170,000 170,000 170,000
Sales € 7,500 € 80,000 €142,500
Less: Interest 32,000 32,000 32,000
Earnings before taxes €(24,500) €48,000 €110,500
Less: Taxes (29% of before-tax earnings) (7,105) 13,920 32,045
Earnings after taxes €(31,605) €34,080 € 78,455
EPS (After-tax earnings ÷ 12,000 shares) € (3.16) € 3.41 € 7.85

Summary statistics – EPS (0% debt):

Expected (EPS) = €2.88
Standard deviation, σEPS = €3.93
Coefficient of variation (EPS) = €3.93 ÷ €2.88 = €1.3646

Share Price*
Debt Expected Common Total = Expected EPS
Ratio (EPS) EPS) CV(EPS) Shares Debt (€) ÷ Required Return

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 0% €2.75 1.6967 0.6145 20,000 0 €2.75÷0.10  €27.50
20% €3.08 2.1281 0.6916 16,000 € 80,000 €3.08÷0.14  €22.00
30% €3.13 2.5323 0.8083 14,000 €120,000 €3.13÷0.16  €19.56
40% €3.08 3.0968 1.0064 12,000 €160,000 €3.08÷0.20  €15.40
50% €2.88 3.928 1.3646 10,000 €200,000 €2.88÷0.24  €12.00
*
Share price: E(EPS)  required return for CV for E(EPS), from table in problem.

b. (1) Optimal capital structure to maximize EPS: 40% debt, 60% equity
(2) Optimal capital structure to maximize share price: 0% debt, 100% equity
c.

P13-26 Integrative: Optimal capital structure (LG 3, 4, 5, 6; Challenge)

a.
%
Total assets Debt ($) Equity ($) Number of shares @ R20
Debt
0% $45,000,000 $ 0 $45,000,000 2,250,000
10% $45,000,000 4,500,000 40,500,000 2,025,000
20% $45,000,000 9,000,000 36,000,000 1,800,000
30% $45,000,000 13,500,000 31,500,000 1,575,000
40% $45,000,000 18,000,000 27,000,000 1,350,000
50% $45,000,000 22,500,000 22,500,000 1,125,000
60% $45,000,000 27,000,000 18,000,000 900,000

b.
% Debt $ Total Debt Before Tax Cost of Debt, rd $ Interest Expense
0 $ 0 0.0% $ 0
10 4,500,000 7.0 315,000
20 9,000,000 8.0 720,000
30 13,500,000 9.5 1,282,500
40 18,000,000 11.0 1,980,000
50 22,500,000 12.5 2,812,500
60 27,000,000 15.5 4,185,000
 c.
% $ Interest Net # of
Debt Expense EBT Taxes Income Shares EPS
0 $ 0 $7,500,000 $3,200,000 $4,500,000 2.250,000 $2.00
10 315,000 7,185,000 3,080,000 4,311,000 2.025,000 2.13
20 720,000 6,780,000 2,944,000 4,068,000 1,800,000 2.26
30 1,282,500 6,217,500 2,768,000 3,730,500 1,575,000 2.37
40 1,980,000 5,520,000 2,496,000 3,312,000 1,350,000 2.45
50 2,182,500 4,687,500 2,200,000 2,812,500 1,125,000 2.50
60 4,185,000 3,315,000 1,712,000 1,989,000 900,000 2.21

d.
% Debt EPS rS P0
0 $2.00 10.0% $20.00
10 2.13 10.3 20.68
20 2.26 10.9 20.73
30 2.37 11.4 20.79
40 2.45 12.6 19.44
50 2.50 14.8 16.89
60 2.21 17.5 12.63

e. The EPS will be maximized when a 50% debt ratio is implemented, but the risk is rather high as is
evident in the required rate of 14.8%. A 30% debt ratio (P0 = $20.79) is recommended, as it will
maximize the price per share of the firm’s common stock, thus maximizing shareholders’ wealth.

P13-27 Integrative: Optimal capital structure (LG 3, 4, 5, 6; Challenge)

a.
Probability
0.20 0.60 0.20
Sales €1,200,000 €1,240,000 €1,280,000
Less: Variable costs (60%) 720,000 744,000 768,000
Less: Fixed costs 400,000 400,000 400,000
EBIT € 80,000 € 96,000 € 112,000
b.
Amount Amount Shares of
Debt Ratio of Debt of Equity Common Stock*
0% € 0 €4,000,000 160,000
30% 1,200,000 2,800,000 112,000
50% 2,000,000 2,000,000 80,000
80% 3,200,000 800,000 32,000
*
Dollar amount of equity  €25 per share  Number of shares of common stock.

c.
Debt Amount Before-Tax Annual

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 Ratio of Debt Cost of Debt Interest
0% € 0 2.0% € 0
30% 1,200,000 2.5 30,000
50% 2,000,000 3.0 60,000
80% 3,200,000 3.5 112,000

d. EPS  [(EBIT  interest) (1  T)]  number of common shares outstanding:

Debt Ratio Calculation EPS
0% (€80,000  €0)  (0.71)  160,000 shares €0.36
(€96,000  $0)  (0.71)  160,000 shares 0.43
(€112,000  $0)  (0.71)  160,000 shares 0.50
30% (€80,000  €30,000)  (0.71)  112,000 shares €0.32
(€96,000  €30,000)  (0.71)  112,000 shares 0.42
(€112,000  €30,000)  (0.71)  112,000 shares 0.52
50% (€80,000  €60,000)  (0.71)  80,000 shares €0.18
(€96,000  €60,000)  (0.71)  80,000 shares 0.32
(€112,000  €60,000)  (0.71)  80,000 shares 0.46
80% (€80,000  €112,000)  (0.71)  32,000 shares €(0.71)
(€96,000  €112,000)  (0.71)  32,000 shares (0.36)
(€112,000  €112,000)  (0.71)  32,000 shares 0

e. (1) Expected (EPS)  0.20(EPS1)  0.60(EPS2)  0.20(EPS3):

Debt Ratio Calculation E(EPS)
0% 0.20  (0.36)  0.60  (0.43)  0.20  (0.50)
0.07  0.26  0.10 €0.43
30% 0.20  (0.32)  0.60  (0.42)  0.20  (0.52)
0.06  0.25  0.10 €0.41
50% 0.20  (0.18)  0.60  (0.32)  0.20  (0.46)
0.04  0.19  0.09 €0.32
80% 0.20  (-0.71)  0.60  (-0.36)  0.20  (0)
-0.14  0.22  0 €0.36
2) EPS

Debt Ratio σEPS

0% 0.04
30% 0.06
50% 0.09
80% 0.22
(3)
 Debt Ratio CV
0% 0.11
30% 0.15
50% 0.28
80% (0.63)

f. (1)

(2)

The return, as measured by the E(EPS), as shown in part d, continually decreases as the debt ratio increases. The risk,
as measured by the CV, also decreases as the debt ratio increases but at a more rapid rate.
g.

The EBIT ranges over which each capital structure is preferred are as follows:
Debt Ratio EBIT Range

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 0% $0 $100,000
30% $100,001 $198,000
To calculate the intersection points on the graphic representation of the EBIT-EPS approach to capital structure, the
EBIT level which equates EPS for each capital structure must be found, using the formula in Footnote 18 of the text:

Set EPS 0% EPS 30%. The first calculation, EPS 0%  EPS 30%, is as follows:
EPS 0% = [(1 0.29)(EBIT) 0) 0]÷160,000 shares
EPS 30% = [(1 0.29)(EBIT) 30,000) 0]÷112,000 shares

79,520 EBIT = 113,600 EBIT 113,600 × 30,000

EBIT = 3,408,000,000÷34,080 = €100,000

The major problem with this approach is failure to focus on shareholder-wealth maximization.

h.
Debt Ratio Share Price
0% €10.65
30% € 9.30
50% € 6.39
80% €(4.44)
i. To maximize EPS, a 0% debt structure is preferred. To maximize share value, a 0% debt structure is preferred. A 0%
debt structure is recommended because it maximizes share value and shareholder wealth.

P13-28 Ethics problem (LG 3; Intermediate)

An information asymmetry occurs when one party has more information than other interested parties. Such an
asymmetry can occur when managers overleverage or lead a company buyout Existing bondholders and possibly
stockholders could be harmed by the financial risk of overleveraging, and existing stockholders will be harmed if
they accept a buyout price below that consistent with accurate and complete information. The board of directors has a
fiduciary duty to stockholders and, hopefully, cares about bondholders as well. The board can and should insist
management divulge all information on the future plans and risks the company faces (taking care, of course, to keep
this out of the hands of competitors). The board should be cautious to select and retain chief executive officers
(CEOs) with high integrity and continue to emphasize an ethical tone “at the top.” (Note: Students will no doubt
think of other creative mechanisms to deal with this situation.)