Capital Structure and Leverage - Solutions7

# Capital Structure and Leverage - Solutions7 - * C. D. E....

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 31 of 59 Pages C. \$225,000 D. \$300,000 * E. \$250,000 Interest = (\$1,500,000)*(.10) = \$150,000 Price per unit = \$3.50 Variable Cost per Unit = (\$3.50)*(.60) = \$2.10 DTL = [(P-V)Q] / [(P-V)Q - F - I] 1.40 = [(\$3.50 - \$2.10)*(1,000,000)] / (\$3.50 - \$2.10)*(1,000,000) - Fixed - \$150,000 1.40 = \$1,400,000 / (\$1,400,000 - Fixed - \$150,000) 1.40 = \$1,400,000 / (\$1,250,000 - Fixed) Fixed = (\$1,750,000 - \$1,400,000) / 1.40 = \$250,000 Proof: Sales \$3,500,000 Variable Costs - \$2,100,000 Fixed Costs - \$ 250,000 EBIT \$1,150,000 Interest - \$ 150,000 EBT \$1,000,000 Taxes - \$ 400,000 Net Income \$ 600,000 33. Assume that Firm A is an unlevered firm with total assets of \$1,000. The probability distribution for its earnings over the coming year is given in the table below. The firm is thinking about issuing \$500 of debt (it will use the proceeds to repurchase their own equity) to increase its expected return on equity. However, whether or not a firm’s use of debt can increase the expected return on equity is a factor of the firm’s cost of debt or the amount of interest that they pay. Given the information above and below, determine the maximum dollar interest the firm can pay before it begins to decrease the expected return on equity. Economy Firm A: Unlevered Bad Average Good Probability 20% 50% 30% EBIT \$100.00 \$150.00 \$220.00 Interest \$0.00 \$0.00 \$0.00 EBT \$100.00 \$150.00 \$220.00 Taxes (40%) -\$40.00 -\$60.00 -\$88.00

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 32 of 59 Pages Net Income \$60.00 \$90.00 \$132.00 BEP 10.00% 15.00% 22.00% ROA 6.00% 9.00% 13.20% ROE 6.00% 9.00% 13.20% A. \$79.70 B. \$77.30 C. \$78.90 * D. \$80.50 E. \$78.10 Leverage will increase the expected return on equity as long as the firm’s expected BEP is greater than the cost of debt. ^ ROE = (.06)*(.2) + (.09)*(.5) + (.132)*(.3) = .012 + .045 + .0396 = 9.66% ^ BEP = (.10)*(.2) + (.15)*(.5) + (.22)*(.3) = .02 + .075 + .066 = 16.1% Maximum Interest = (\$500)*(.161) = \$80.50 Proof: Economy Firm A: Unlevered Bad Average Good Probability 20% 50% 30% EBIT \$100.00 \$150.00 \$220.00 Interest -\$80.50 -\$80.50 -\$80.50 EBT \$19.50
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## This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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Capital Structure and Leverage - Solutions7 - * C. D. E....

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