318 LEVERAGE AND CAPITAL STRUCTURE [CHAP.

11
CHAP. 11] LEVERAGE AND CAPITAL STRUCTURE 319

equity remain the same. (1) Compute the new total value of the firm and the firm’s overall cost
of capital, and (2) determine the firm’s market debt/equity ratio.
SOLUTION

(a) EBIT ¼ $10,000,000

I ¼ $20,000,000 ~ 7% ¼ $1,400,000
k e ¼ 12:5%

(1) The total value of the firm, V, can be found as follows:

EAC ¼ EBIT — I ¼ 10,000,000 — $1,400,000 ¼ $8,600,000

EAC
S¼ ¼
$8,600,000
ke
¼ $68,800,000
0:125
V ¼ S þ B ¼ $68,800,000 þ $20,000,000 ¼
$88,800,000
Therefore, EBIT
ko ¼
$10,000,000
¼ ¼ 11:26%
V $88,800,000
(2) The firm’s market debt/equity ratio is:
B

$20,000,000
(b) (1) ¼ ¼ 29% ~ 7% ¼
I ¼ $30,000,000
S $68,800,000
$2,100,000
EAC ¼ EBIT — I ¼ $10,000,000 — $2,100,000 ¼
$7,900,000 EAC
S¼ ¼
$7,900,000
ke
¼ $63,200,000
0:125
V ¼ S þ B ¼ $63,200,000 þ $30,000,000 ¼
$93,200,000
Therefore, EBIT
ko ¼
$10,000,000
¼ ¼ 10:73%
V $93,200,000
(2) The debt/equity ratio
is:
B $30,000,000
¼ ¼ 47%
S $63,200,000

11.5 The NOI Approach. Assume the same data as given in Problem 11.4. (a) Using the net operating
income (NOI) approach and an overall cost of capital of 12 percent; (1) compute the total value,
the stock market value of the firm, and the cost of equity; and (2) determine the firm’s market
debt/equity ratio. (b) Determine the answer to (a) if the company were to sell the additional $10
million in debt, as in Problem 11.4(b).
SOLUTION
(a) EBIT ¼ $10,000,000
k o ¼ 12%
EAC ¼ $8,600,000

EBIT
(1) V¼ ¼ ¼
$10,000,000
ko
$83,330,000
12%
S ¼ V — B ¼ $83,330,000 — $20,000,000 ¼
$63,330,000
320 LEVERAGE AND CAPITAL STRUCTURE [CHAP. 11

Therefore,

EAC
ke ¼
$8,600,000
¼ ¼ 13:6%
S $63,330,000
(2) The debt/equity ratio is:
B $20,000,000
¼ ¼ 31:58%
S $63,330,000
(b) (1) S ¼ V — B ¼ $83,330,000 — $30,000,000 ¼
$53,330,000
Therefore,
EAC
ke ¼
$8,600,000
¼ ¼ 16:1%
S $53,330,000
(2) The debt/equity ratio is:
B $30,000,000
¼ ¼ 56:3%
S $53,330,000
CHAP. 11] LEVERAGE AND CAPITAL STRUCTURE 327

11.13 Rate of Return and Optimal Capital Structure. Central Furniture Company recently announced
plans to expand its production capacity by building and equipping two new factories to operate
in parallel with existing production facilities. The expansion will double the assets of the firm.
The proposed expansion has received a lot of attention from industry observers due to the
cyclical nature of the furniture industry and the size of the project. The new plants will require
fewer workers than current plants of similar capacity because the new facilities will be highly
automated.
Central Furniture must now decide how the plant expansion will be financed. The project will
require $5 million in new funds and the expected return on the new assets is estimated at
12
percent before taxes, the same return that is currently earned on the existing assets. The two
alternatives proposed to raise the needed funds are (1) private placement of long-term debt at an
interest rate of 10 percent, and (2) issuance of new common stock at $25 per share.
Currently the company is financed equally by debt and equity as follows:
Long-term debt (8%) $2,500,000
Common stock ($1 par) $ 100,000
Paid-in capital on common stock $ 400,000
Retained earnings $2,000,000

Central Furniture’s common stock is currently traded on a stock exchange at a market price
of $27 per share. Central Furniture is subject to a tax rate of 40 percent.
(a) Compute Central Furniture Company’s anticipated rate of return on stockholders’ equity
if the expansion project is financed by (1) private placement of long-term debt, and (2)
issuance of common stock. (b) One of the two alternatives–long-term debt or common stock–
will move Central Furniture Company to a more optimum capital structure. (1) What criteria
are used to judge optimum capital structure? (2) Explain what factors influence the
determination of an optimum capital structure. (CMA, adapted.)
SOLUTION

(a) (1) Earnings before interest and taxes $1,200,000

($10,000,000 ~ 0.12)
Less: Interest expense
Present debt (0.08 ~ $2,500,000) $200,000
New debt (0.10 ~ $5,000,000) 700,000
Earnings before taxes 500,000 $ 500,000
Taxes (40%) 200,000
Net income $ 300,000

$300,000
Return on stockholders’ equity ¼ ¼ 12%
$2,500,000
(2) Earnings before interest and taxes $1,200,000
($10,000,000 ~ 0.12)
Less: Interest expense 200,000
(0.08 ~
$2,500,000)
Earnings before taxes $1,000,000
Taxes (40%) 400,000
Net income $ 600,000

$600,000
Return on stockholders’ equity ¼ ¼ 8%
$7,500,000
328 LEVERAGE AND CAPITAL STRUCTURE [CHAP. 11

(b) (1) Optimum capital structure is the lowest weighted average cost of capital that a given firm is able
to obtain given its risk constraints. (2) The optimum capital structure for a firm is influenced by
the relationship of its return to the risks of earning the return. Specific factors influencing these
two items would include:
1. The growth rate of income
2. Cash flow available to service debt
3. The amount of operating risk
4. Lender and investor interpretation of the financial risk of the firm and industry

11.14 Alternative Sources of Financing. The Drew Furniture Company is considering the introduction of
a new product line. Plant and inventory expansion equal to 50 percent of present asset levels will
be necessary to handle the anticipated volume of the new product line. New capital will have to
be obtained to finance the asset expansion. Two proposals have been developed to provide the
added capital.
5. Raise the $100,000 by issuing 10-year 12 percent bonds. This will change the capital structure
from one with about 20 percent debt to one with almost 50 percent debt. The investment
banking house estimates the price/earnings ratio, now 12 to 1, will be reduced to 10 to 1 if
this method of financing is chosen.
6. Raise the $100,000 by issuing new common stock. The investment banker believes that the
stock can be issued to yield $3331. The price/earnings ratio would remain at 12 to 1 if the stock
were issued. The present market price is $36.
The company’s most recent financial statements are as
follows:
Drew Furniture Company
Balance Sheet
As of December 31, 20XI
ASSETS EQUITIES
Current $ 65,000 Debt 5% $ 40,000
Plant and equipment 135,00 Common stock 100,000
0
Retained earnings 60,000
$200,00 $200,000
0
Income Statement
For the Year Ended December 31, 20X1
Sales $600,00
0
Operating costs 538,000
Operating income $ 62,000
Interest charges 2,000
Net income before taxes $ 60,000
Federal income taxes 30,000
Net income $ 30,000

(a) The vice-president of finance asks you to calculate the earnings per share and the market value
of the stock (assuming the price/earnings ratios given are valid estimates) for the two proposals
assuming total sales (including the new product line) of: (1) $400,000; (2) $600,000; and (3)
$800,000. Costs exclusive of interest and taxes are about 90 percent of sales. (b) Which proposal
would you recommend? Your answer should indicate: (1) the criteria used to judge the alterna-
tives; (2) a brief defense of the criteria used; and (3) the proposal chosen in accordance with the
criteria. (c) Would your answer change if a sales level of $1,200,000 or more could be achieved?
CHAP. 11] LEVERAGE AND CAPITAL STRUCTURE 329

Explain. (d ) What reasons(s) would the investment broker give to support the estimate of a
lower price/earnings ratio if debt is issued? (CMA, adapted.)
SOLUTION
(a) Proposal 1, for 10-year 12 percent bonds:

Drew Furniture Company

Income Statement
For the Year Ended December 31, 20X1
Estimated Sales Levels
Sales $400,00 $600,000 $800,000
0
Operating costs 360,000 540,000 720,000
Operating income $ 40,000 $ 60,000 $ 80,000
Interest charges 14,000 14,000 14,000
Net income before taxes $ 26,000 46,000 $ 66,000
Federal income taxes 13,000 23,000 33,000
Net income $ 13,000 $ 23,000 $ 33,000

30,000
Outstanding shares ¼ 10,000

Earnings per share $1.30 $2.30 $3.30

Price/earnings ratio 10 times 10 times 10 times
Estimated market value $31 $23 $33

Proposal 2, for common stock issue to yield $3331:

Drew Furniture Company

Income Statement For the Year
Ended December 31, 20X1
Esti
mat
Sales $400,00 $600,000 $800,000
0 ed
Operating costs 360,000 Sal 540,000 720,000
es
Operating income $ 40,000 $ 60,000 $ 80,000
Lev
Interest charges 2,000 els 2,000 2,000
Net income before taxes $ 38,000 $ 58,000 $ 78,000
Federal income taxes 19,000 29,000 39,000
Net income $ 19,000 $ 29,000 $ 39,000
100,000
Outstanding shares ¼ þ 10,000 ¼ 13,000 shares
3331
Earnings per share $1.46 $2.23 $3.00
Price/earnings ratio 12 times 12 times 12 times
Estimated market value $17.52 $26.76 $36.00

(b) Within the constraints of this problem, two possible objectives emerge: profit maximization as mea-
sured by earnings per share, and wealth maximization as measured by the price of the common stock.
If profit maximization is used, the firm should choose to finance the new product by selling bonds,
since earnings per share is higher for each of the three levels of sales. On the other hand, wealth
maximization would require the sale of new common stock because stock price is higher at each sales
level.
330 LEVERAGE AND CAPITAL STRUCTURE [CHAP. 11

Wealth maximization is the preferred criterion for financial decision making. Unlike profit max-
imization, wealth maximization represents a measure of the total benefits to be enjoyed by the share-
holders, adjusted for both the timing of benefits and the risk associated with their receipt. A criterion
which ignores these two important determinants of value cannot be expected to provide a proper guide
to decision making.
Because wealth maximization is the preferred objective, the sale of common stock is the recom-
mended financing technique.
(c) Proposal 2 would still be the choice because the market value remains above that of proposal 1. The
difference is smaller than is shown with the lower sales estimates, which means that proposal 1 would
become attractive if sales reached a higher level (approximately $1.6 million).
(d ) The investment banker would suggest that the lower price/earnings ratio with debt financing is a
reflection of the greater returns demanded by stockholders in compensation for the greater variability
in earnings and higher risk of bankruptcy created by the fixed commitment to pay debt interest and
principal.
 Examination II
Chapters 6–11

I. Put a T (true) or F (false) in the space provided below:

1. Finding present values is simply the inverse of compounding.
2. A perpetuity is an annuity that continues for 20 years.
3. Risk is defined as the variation in returns about a standard deviation.
4. Through diversification, an investor can reduce the systematic risk, or beta.
5. A proxy for the risk-free rate is the Treasury bills yield.
6. The cost of capital is the weighted average of the various capital costs.
7. Total leverage is the product of operating leverage and financial leverage.
8. The optimal capital structure can be defined as the mix of financing sources that
minimize the company’s debt cost.
9. Projects that are negatively correlated tend to be less risky than those that move
together in the same direction.
The NPV method and the IRR approach assume the same rate for reinvestment.
10.
II. Select the best answer:

1. Which of the following takes into account the time value of money?
(a) Average rate of return
(b) Payback period
(c) Internal rate of return (d )
None of the above
2. The NPV method and the
IRR method may produce
conflicting ranking when
(a) projects are mutually
exclusive
(b) projects are
independent and not
competing for limited
funds
(c) both of the above (d )
none of the above
3. Which of the following
is concerned with the
relationship between
the firm’s EBIT and
EPS?
(a) Beta
(b) Operating
leverage
(c) Sales revenue
(d ) Financial leverage
4. Through diversification a firm can stabilize its earnings and most effectively reduce its risk when
332 EXAMINATION II

5. Under the CAPM, the required rate of return on a security is the sum of a risk premium and
(a) financial risk
(b) operating risk
(c) diversifiable risk (d )
risk-free rate
6. All the following elements are necessary for the computation of the cost of common stock under the
Gordon’s growth model, except
(a) tax rate
(b) growth rate in dividends or earnings
(c) market price (d )
dividend
7. Which one of
the following
must be adjusted
for taxes?
(a) Cost of
retained
earnings
(b) Cost of
common
stock
(c) Cost of preferred stock (d )
Cost of debt
8. Which of the following is
not a method for adjusting
for risk in capital
budgeting?
(a) Risk-adjusted rate
(b) Simulation
(c) Certainty equivalent approach (d )
(a) stocks/bonds
Break-even analysis
(b) stocks ~
9. The traditional approach to capital
bonds + bonds
(c) stocks
structure implies
(d ) none of the above
(a) there is a minimum cost of
capital that is determined by
III. an optimal capital structure
(b) there is no such things as
1. If a firm’s earnings
optimal capitaland dividends grow from $2.15 per share to $4 per share over an 8-year period,
structure
what is the rate of growth?
(c) all the above
(d ) none of the above
2. How much would you be willing to pay today for an investment that would return $1,250 each year
10. for the
The nextexpression
simple 10 years, assuming a discount rate of 12 percent?
for the total
value of the firm is
3. The risk-free rate is 5 percent, the market return is 12 percent and the stock’s beta coefficient is 1.25.
If the dividend expected during the coming year is $3 and grows at an 8 percent rate, at what price
should the stock sell?
 EXAMINATION II 333

4. The Sawyer Company has just issued $10 million of $1,000, 8 percent, 10-year bonds. Due to the
current market rates the firm had to sell the bonds at a discount of $40 from their face value. (a)
Calculate the before-tax cost, or yield to maturity, of the bond, using the shortcut formula, and
(b) calculate the after-tax cost of the bond, assuming the firm’s tax rate is 40 percent.

5. The Desert Products Company is considering six investment proposals of similar risk, for which the
funds available are limited. The projects are independent and have the following initial investment
and present values of cash inflows associated with them:

Project Initial Cost (I) ($) PV ($)

A 15,000 21,000
B 8,000 12,000
C 5,000 7,500
D 4,000 6,400
E 2,000 3,500
F 1,000 1,900

(a) Compute the profitability index and NPV for each project. (b) Under capital rationing, which
projects should be selected, assuming a total budget of $25,000? (c) Which projects should be
selected if the total budget is reduced to $24,000?

6. A firm is considering two alternative plans to finance a proposed $7 million investment. Plan A:
Issue debt (9 percent interest rate). Plan B: Issue common stock (at $20 per share, 1 million shares
currently outstanding). The company’s income tax rate is 40 percent. (a) Calculate the indifference
level of EBIT, or the break-even point for each plan, and (b) plot these two plans on the EBIT-EPS
chart.

7. ABC System, Inc., plans to sell new shares of common stock at $35. The flotation cost is 10 percent.
What is the cost of external equity? Both earnings and dividends are expected to grow at a
constant rate of 6 percent and the annual dividend per share is $2.

8. Alta-Data, Inc., is considering an investment proposal. The company’s board of directors indicated
that the firm’s present 70 percent owners’ equity and 30 percent long-term debt structure should
be maintained. The company’s projected earnings accompanied by periodic common stock sales
will permit it to maintain the present 70 percent owners’ equity structure of 40 percentage points
from retained earnings and 30 percentage points from common stock.
After consultation with the firm’s investment banker, the company has determined that the
debt could be sold to yield 9 percent and new common stock could be sold to provide proceeds of
$40 per share to the firm. The company is currently paying a dividend of $2 per share, and the
dividends are expected to grow at a constant rate of 6 percent. The firm’s income tax rate is 40
percent.
Calculate the after-tax cost of capital that the company can use for its capital budgeting
decision.

Answers to Examination II

I. 1. T; 2. F; 3. F; 4. F; 5. T; 6. T; 7. T; 8. F; 9. T; 10. F

II. 1. (c); 2. (a); 3. (d ); 4. (c); 5. (d ); 6. (a); 7. (d ); 8. (d ); 9. (a); 10. (c)

334 EXAMINATION II

III.

1. Fn¼ PFVIF i;n

.
$4:00 ¼ $2:15ΣFVIF i;8
$4:0
FVIF i;8 ¼ 0 ¼ 1:8605
$2:15
From Appendix A, FVIF 8 % , 8 = 1.8509. Therefore, the firm’s approximate rate of growth is 8 percent.
. Σ
2. PV ¼ $1,250 PVIFA 12%;10 ¼ $1,250ð5:6502Þ ¼ $7,062:75

3. r ¼ rf þ bðrm — rfÞ
¼ 5% þ 1:25ð12% — 5%Þ ¼ 5% þ 8:75% ¼
13:75%
D1 $3
P0 ¼ ¼ ¼
r — g 13:75% $3 — 8%
¼ $52:17
0:0575
I þ ððM — VÞ=nÞ $ 80 þ
4. Yield to maturity ¼
(a) ð$1,000 — $960Þ=10 ðM þ VÞ=2
$ 80 þ
¼ ¼ ¼ 8:57%
$4 ð$1,000 þ $960Þ=2
$980
After-tax cost of debt ¼ 8:57%ð1 — 0:4Þ ¼
(b)
5:14%

5. (a) NPV = PV — I and the profitability index is PV/I.

Initial Cost Profitability
Project (I) ($) NPV ($) Index (PI)
A 15,000 6,000 1.40
B 8,000 4,000 1.50
C 5,000 2,500 1.50
D 4,000 2,400 1.60
E 2,000 1,500 1.75
F 1,000 900 1.90

(b) Project I PV NPV PI

A $ 5,100 $21,000 $ 6,000 1.40
C 5,000 7,500 2,500 1.50
D 4,000 6,400 2,400 1.60
F 1,000 1,900 900 1.90
Totals $25,000 $36,800 $11,800

No combination within the $25,000 total budget constraint would show as much NPV as the one listed
above. Note that project E is not included even though its 1.75 PI is higher than three of the included
projects.
(c) Project I PV NPV PI
B $ 8,000 $12,00 $ 4,000 1.50
0
C 5,000 7,500 2,500 1.50
D 4,000 6,400 2,400 1.60
E 2,000 3,500 1,500 1.75
F 1,000 1,900 900 1.90
Totals $20,000 $31,30 $11,300
0
 EXAMINATION II 335

It is not necessary to use all the available $24,000 budget in order to maximize NPV. For example, two
combinations that do use the entire $24,000 but which have lower NPV are shown below.

Project I PV NPV PI
A $15,000 $21,00 $ 6,000 1.40
0
B 8,000 12,000 4,000 1.50
F 1,000 1,900 900 1.90
Totals $24,000 $34,90 $10,900
0

Project I PV NPV PI
A $15,000 $21,00 $ 6,000 1.40
0
C 5,000 7,500 2,500 1.50
z D 4,000 6,400 2,400 1.60
Totals $24,000 $34,90 $10,900
0
6. ðEBITÞð1 0:4Þ ðEBIT — $900,000Þð1 —
(a) ¼
— 1,500,000 0:4Þ
1,000,000
Break — even EBIT ¼
$2,700,000
(b) See Fig. E-1.

D1
7. ke ¼ þ g
P0ð1 —
fÞ 2:00ð1 þ
$ $
¼ þ 6% ¼ þ 6% ¼ 6:7% þ 6% ¼
0:06Þ
$35ð1 — 0:1Þ 2:12
12:7%
$31:5
8. After-tax cost of debt = 9%(1 — 0.4) =
5.4%
D1
Cost of new common stock ¼ þ g þ 6% ¼ 11%
$2:00
P0
¼
$2:0
$40
Cost of retained earnings ¼ 0 þ 6% ¼ 10:76%
$42

Fig. E-1
336 EXAMINATION II

Therefore, the after-tax cost of capital, or weighted average of individual capital component costs, is
computed as follows:

Weighted
Weights Average
Debt, 5.4% 0.3 1.62%
New common stock, 11% 0.4 4.4
Retained earnings, 10.76% 0.3 3.23
After-tax cost of capital 9.25%