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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- Summer '15
- Corporate Finance, Cost Of Capital, Leverage, Total capital