Student Ch13 - Chapter 13 Capital Structure and Leverage...

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Chapter 13 – Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory Campus Deli Inc.’s Optimal Capital Structure Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were $1,100,000 last year; variable costs were 60 percent of sales; and fixed costs were $40,000. Therefore, EBIT totaled $400,000. Because the university’s enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD pays out all earnings as dividends. Assets are $2 million, and 80,000 shares are outstanding. The management group owns about 50 percent of the stock, which is traded in the over-the- counter market. CD currently has no debt—it is an all-equity firm and its 80,000 shares outstanding sell at a price of $25 per share, which is also the book value. The firm’s federal-plus-state tax rate is 40 percent. On the basis of statements made in your finance text, you believe that CD’s shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea, but to provide support for the suggestion. In today’s market, the risk-free rate, r RF , is 6 percent and the market risk premium, RP M , is 6 percent. CD’s unlevered beta, b U , is 1.0.
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CD currently has no debt, so its cost of equity (and WACC) is 12 percent. If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD.
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C. To develop an example of the effects of financial leverage, that can be presented to CD’s management as an illustration, consider two hypothetical firms, Firm U, with zero debt financing, and Firm L, with $10,000 of 12 percent debt. Both firms have $20,000 in total assets and a 40 percent federal-plus-state tax rate, and they have the following EBIT probability distribution for next year: Probability EBIT 0.25 $2,000 0.50 3,000 0.25 4,000 (1) Complete the partial income statements and the firms’ ratios Table IC 13-1.  Income Statements and Ratios Firm U (Unleveraged) Firm L (Leveraged) Assets $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 Equity $20,000 $20,000 $20,000 $10,000 $10,000 $10,000 Probability 0.25 0.50 0.25 0.25 0.50 0.25 Sales $ 6,000 $ 9,000 $12,000 $ 6,000 $ 9,000 $12,000 Oper. costs 4,000 6,000 8,000 4,000 6,000 8,000 EBIT $ 2,000 $ 3,000 $ 4,000 $ 2,000 $ 3,000 $ 4,000 Int. (12%) 0 0 0 1,200 1,200 EBT $ 2,000 $ 3,000 $ 4,000 $ 800 $ $ 2,800 Taxes (40%) 800 1,200 1,600 320 1,120 Net income $ 1,200 $ 1,800 $ 2,400 $ 480 $ $ 1,680 BEP 10.0% 15.0% 20.0% 10.0% % 20.0% ROE 6.0% 9.0% 12.0% 4.8% % 16.8% TIE 1.7 × × 3.3 × E(BEP) 15.0% % E(ROE) 9.0% % E(TIE) 2.5 × σ BEP 3.5% % σ ROE 2.1% 4.2%
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Student Ch13 - Chapter 13 Capital Structure and Leverage...

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