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# Ch16+Answers+to+assigned+problems+v6 - CHAPTER 16 FINANCIAL...

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CHAPTER 16 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. The final answer for each problem is found without rounding during any step in the problem. Basic 1. a. A table outlining the income statement for the three possible states of the economy is shown below. The EPS is the net income divided by the 2,500 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. Recession Normal Expansion EBIT \$5,600 \$14,000 \$18,200 Interest 0 0 0 NI \$5,600 \$14,000 \$18,200 EPS \$ 2.24 \$ 5.60 \$ 7.280 % EPS –60 ––– +30 b. If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstanding Share price = \$150,000/2,500 Share price = \$60 Shares repurchased = Debt issued / Share price Shares repurchased =\$60,000/\$60 Shares repurchased = 1,000 The interest payment each year under all three scenarios will be: Interest payment = \$60,000(.05) = \$3,000 The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization. Recession Normal Expansion EBIT \$5,600 \$14,000 \$18,200 Interest 3,000 3,000 3,000 NI \$2,600 \$11,000 \$15,200 EPS \$1.73 \$ 7.33 \$10.13 % EPS –76.36 ––– +38.18 NI \$3,640 \$9,100 \$11,830 EPS \$1.46 \$3.64 \$4.73 % EPS –60 ––– +30

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4. a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be: EPS = \$200,000/150,000 shares EPS = \$1.33 Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so: NI = \$200,000 – .10(\$1,500,000) NI = \$50,000 And the EPS will be: EPS = \$50,000/60,000 shares EPS = \$0.83 Plan I has the higher EPS when EBIT is \$200,000. b. Under Plan I, the net income is \$700,000 and the EPS is: EPS = \$700,000/150,000 shares EPS = \$4.67 Under Plan II, the net income is: NI = \$700,000 – .10(\$1,500,000) NI = \$550,000 And the EPS is: EPS = \$550,000/60,000 shares EPS = \$9.17 Plan II has the higher EPS when EBIT is \$700,000. c. To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is: EBIT/150,000 = [EBIT – .10(\$1,500,000)]/60,000 EBIT = \$250,000 5. We can find the price per share by dividing the amount of debt used to repurchase shares by the number of shares repurchased. Doing so, we find the share price is: Share price = \$1,500,000/(150,000 – 60,000) Share price = \$16.67 per share The value of the company under the all-equity plan is: V = \$16.67(150,000 shares) = \$2,500,000 And the value of the company under the levered plan is: V = \$16.67(60,000 shares) + \$1,500,000 debt = \$2,500,000
6. a. The income statement for each capitalization plan is: I II All-equity EBIT \$10,000 \$10,000 \$10,000 Interest 1,650 2,750 0 NI \$8,350 \$7,250 \$10,000 EPS \$7.59 \$ 8.06 \$ 7.14 Plan II has the highest EPS; the all-equity plan has the lowest EPS. b. The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is calculated as: EPS = (EBIT – R D D)/Shares outstanding This equation calculates the interest payment (R D D) and subtracts it from the EBIT, which results in the net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the interest term is zero. To find the breakeven EBIT for two different capital structures, we simply set the

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