61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 9– CAPITAL STRUCTURE AND LEVERAGE

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Questions & problems

1. Which of the following would likely encourage a firm to increase the debt in its capital structure?
(Hint: relate your answer with the relevant capital structure theory):
a. The coporate tax increases
b. The personal tax increases
c. Due to market changes, the firm’s assest become less liquid.
d. Changes in the bankruptcy codes make bankruptcy less costly to the firm.
e. The firm’s sales and earnings become more volatile.

2. Why is EBIT generally considered independent of financial leverage? Why might EBIT actually be
affected by financial leverage at high debt levels?
3. Is the debt level tha maximizes a firm’s expected EPS the same as the debt level that maximize stock
price? Explain?

4. The Weaver Watch Company sells watches for $25, the fixed costs are $140,000, and variable costs
are $15 per watch.
a. What is the firm’s gain or loss at sales of 8,000 watches? At 18,000 watches?
b. What is the break-even point? Illustrate by mean of a chart.
c. What would happen to the break-even point if the selling price was raised to $31? What is the
significance of this analysis?
d. What would happen to the break-even point if the selling price was raised to $31 but variable
costs rose to $23 a unit?
5. Jackson Trucking Company is in the process of setting its target capital structure. The CFO believes
that the optimal debt-to-capital ratio is somewhere between 20% to 50%, and her staff has
compiled the following projections for EPS and the stock price at various debt levels:

Assuming that the firm uses only debt and common equity, what is Jackson’s optimal capital
structure? At what deb-to-capital ratio is the company’s WACC minimized?
6. The Neal Company wants to estimate next year’s ROE under different financial leverage ratios.
Neal’s total capital is $14 million, it currently uses ony common equity, it has no future plan to use
preferred stock in its capital structure, and its federal-plus-state tax rate is 40%. The CFO has
estimated next year’s EBIT for three possible states of the world: $4.2 million with a 0.2 probability,
$2.8 million with a 0.5 probability, and $700,000 with a 0.3 probability. Calculate Neal’s expected
ROE, standard deviation, coefficient of variation for each of the following debt-to-capital ratios; then
evaluat the resutls: