Capital Structure and Leverage C H A P T E R 1 4 - P R O B L E M S B ASIC C ONCEPTS AND C ALCULATIONS : T ABLES 14-1, 14-2, AND E QUATION 14.1 ( PAGES 600, 601, AND 602) 1. The Connecticut Computer Company has the following selected financial results. 10% Debt 40% Debt 75% Debt Debt $ 10,000 Equity 90,000 Total Capital $100,000 Shares @ $5 18,000 EBIT $18,000 Interest ( 15%) 1,500 EBT $16,500 Tax (40%) 6,600 EAT $ 9,900 ROE EPS The company is considering a capital restructuring to increase leverage from its present level of 10% of capital. a. Calculate Connecticut’s ROE and EPS under its current capital structure. b. Restate the financial statement line items shown, the number of shares outstanding, ROE, and EPS if Connecticut borrows money and uses it to retire stock until its capital structure is 40% debt assuming EBIT remains unchanged and the stock continues to sell at its book value. (Develop the second column of the chart shown.) c. Recalculate same figures assuming Connecticut continues to restructure until its capital structure is 75% debt. (Develop the third column of the chart.) d. How is increasing leverage affecting financial performance? What overall effect might the changes have on the market price of Connecticut’s stock? Why? (Words only. Hint: consider the move from 10% to 40% and that from 40% to 75% separately.)
2. Reconsider the Connecticut Computer Company of the previous problem assuming the firm has experienced some difficulties, and its EBIT has fallen to $8,000. a. Reconstruct the three-column chart developed in problem 1 assuming Connecticut’s EBIT remains at $8,000. b. Interpret the result in terms of stock price and the advisability of restructuring capital under these conditions. c. Could these results have been predicted more easily? Use the ROCE concept to come to the same conclusion.