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# Chapter 14-Spreadsheet Model - 14 Chapter model Chapter 14...

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14 Chapter model 1/06/09 Chapter 14. Capital Structure and Leverage Input Data Plan A Plan B Low FC High FC Price (P) \$2.00 \$2.00 Variable costs (V) \$1.50 \$1.00 Fixed costs (F) \$20,000 \$60,000 Total assets (A) \$200,000 \$200,000 Tax Rate (T) 40% 40% A's breakeven units = 40,000. B's breakeven units = 60,000. Operating Performance Plan A: Low Fixed, High Variable Costs Plan B: High Fixed, Low Variable Costs Data Applicable to Both Plans Units Dol ar Operating Operating Demand Probability Sold Sales Costs EBIT ROE Costs EBIT ROE Ter ible 0.05 0 \$0 \$20,000 (\$20,000) (\$12,000) -6.0% \$60,000 (\$60,000) (\$36,000) -18.0% Poor 0.2 40,000 \$80,000 \$80,000 \$0 \$0 0.0% \$100,000 (\$20,000) (\$12,000) -6.0% Average 0.5 100,000 \$200,000 \$170,000 \$30,000 \$18,000 9.0% \$160,000 \$40,000 \$24,000 12.0% Good 0.2 160,000 \$320,000 \$260,000 \$60,000 \$36,000 18.0% \$220,000 \$100,000 \$60,000 30.0% Wonderful 0.05 200,000 \$400,000 \$320,000 \$80,000 \$48,000 24.0% \$260,000 \$140,000 \$84,000 42.0% Expected Values: 100,000 \$200,000 \$170,000 \$30,000 \$18,000 9.00% \$160,000 \$40,000 \$24,000 12.00% Standard Deviation (SD): 49,396 \$98,793 \$24,698 7.41% \$49,396 14.82% Coef icient of Variation (CV): 0.49 0.49 0.82 0.82 1.23 1.23 The results generated above are graphed here: Further discus ion of Operating Leverage (Beyond the scope of Concise FFM, but interesting) SDs are the standard deviations of the as et and the market. 2. We could estimate the SD of the market, based on historical data. The approximate SD for large company stocks is 27.9%, and 25.76% for smal company stocks. As ume SD Market = 25% 4. As ume that Bigbe 's management estimates the project cor elation with the market to be 0.75. So, the returns move up and down with the market, which is typical. 0.75 5. We calculated above the SD for A and B as fol ows: SD(A) = 7.41% SD(B) = 14.82% 6. We can now apply the formula to find betas for Plans A and B: A's beta = 0.22 B's beta = 0.44 These betas could be used in the Hamada equation as described below to bring in financial risk and thus to get an idea of total risk with dif erent operating and financial plans. 7. This type analysis is not commonly applied because of the dif iculty of obtaining suf iciently ac urate data. However, it is useful as a framework for thinking about the is ues. Moreover, as market and operating data become increasingly available, the framework wil become increasingly operational. Plan A F / (P V) \$20,000 / \$2.00 \$1.50 40,000 Units. Plan B F / (P V) \$60,000 / \$2.00 \$1.00 60,000 Units. Debt Cost Schedule Amount Cost of D/A ratio bor owed debt 0% \$0 8.0% 10% \$20,000 8.0% 20% \$40,000 8.3% 30% \$60,000 9.0% 40% \$80,000 10.0% 50% \$100,000 12.0% 60% \$120,000 15.0% OPTION 1: Finance Plan B entirely with common equity (Equity = 100%, Debt = 0%) Assets \$200,000 Debt ratio 0% Equity Ratio 100% Debt \$0 Equity \$200,000 Interest rate 8.00% Interest rate from debt cost schedule above. Tax rate

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Chapter 14-Spreadsheet Model - 14 Chapter model Chapter 14...

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