b Discuss the effect the options might have on stock price c Make a subjective

# B discuss the effect the options might have on stock

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b. Discuss the effect the options might have on stock price. c. Make a subjective recommendation under each of the following assumptions about the \$4 million forecast. Support your position with words and references to your EBIT-EPS analysis. 1. The \$4 million Operating Profit projection is a best-case scenario. Anything from (\$2 million) to \$4 million has an equal probability of occurring. 2. The \$4 million is a fair estimate with about a 60% probability. However, performance better than \$4 million is unlikely. EBIT results could range anywhere from zero to \$4 million. 3. \$4 million is an easy target. There's an even chance of anything between \$4 million and \$8 million. 5
Capital Structure and Leverage SOLUTION: Preliminaries – Current Financial Statement Items and Capital Structure (i.e. before the additional \$15 M in Capital): Financial Statement Items Current Capital Structure EBIT \$ 1.00 M Debt \$ 2 M Interest (@ 10%) \$ 0.20 M Equity \$ 3 M EBT \$ 0.80 M Total Capital \$ 5 M Taxes (@ 40%) \$ 0.32 M EAT \$ 0.48 M BV per Share = \$ 10 per Share Number of Shares Outstanding = \$ 3 M \$ 10 per Share = . 3 M EPS = \$ 0.48 M .3 M = \$1.60 EPS AS A L INEAR F UNCTION OF EBIT: D = Debt, E = Equity & TC = Total Capital. TC = D + E k d = Interest Rate on Debt, I = Interest Amount & I = k d · D T = Average Combined Tax Rate N = # of Outstanding Shares EPS = EAT N = EBT ( 1 T ) N = ( EBIT k d ∙D ) ( 1 T ) N = ( 1 T ) N ∙EBIT ( k d ∙D ) ( 1 T ) N Assuming Share Price = BV per share: N = E BV per Share = TC D BV per Share When the \$15M in new capital is added: TC = \$ 20 M, k d = 10%, T = 40% and BV per Share = \$10 . Thus, 6
Capital Structure and Leverage ¿ EPS = 6 20 D ∙EBIT . 6 ∙ D 20 D N OTE : D varies with Capital Structure option (1), (2) or (3). 7
Capital Structure and Leverage a. O PTION 1: Firm raises new \$15M as “ All Equity Option 1 Capital Structure Debt \$ 2 M (10%) Equity \$ 18 M (90%) Total Capital \$ 20 M BV per Share = \$10 per Share Plug D 1 = \$2M into equation * at the bottom of the 2 nd blue box above to obtain, ¿ EPS = 0.333 ∙ EBIT .067 This linear relationship is graphed below. O PTION 2: Firm raises new \$15M as “ \$8M Debt & \$7M Equity Option 2 Capital Structure Debt \$ 10 M (50%) Equity \$ 10 M (50%) Total Capital \$ 20 M BV per Share = \$10 per Share Plug D 2 = \$10M into equation * at the bottom of the 2 nd blue box above to obtain, ¿ EPS = 0.6 ∙ EBIT 0.6 This linear relationship is graphed below. O PTION 3: Firm raises new \$15M as “ All Debt Option 3 Capital Structure Debt \$ 17 M (85%) Equity \$ 3 M (15%) Total Capital \$ 20 M BV per Share = \$10 per Share Plug D 3 = \$17M into equation * at the bottom of the 2 nd blue box above to obtain, ¿ EPS = 2 ∙EBIT 3.4 This linear relationship is graphed below. 8
Capital Structure and Leverage \$0 \$1 \$2 \$3 \$4 -\$4 -\$3 -\$2 -\$1 \$0 \$1 \$2 \$3 \$4 \$5 EBIT - EPS Analysis EBIT (\$M's) EPS N OTE : As the % of Debt in the capital structure increases (i.e. going from option 1, to option 2, and then to option 3), EPS changes more for the same change in EBIT. This can be good news (when EBIT is large – favoring Option 3) or bad news (when EBIT is small– favoring Option 1). b. The three options display a wide range of choices with respect to the trade-off between risk and performance.

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