Chapter 11 Case : Evaluating McGraw Industries' Capital Structure
McGraw Industries, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm's management has been instructed by its board to institute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value.
In this regard, the firm's chief financial officer (CFO), Ron Lewis, has been charged with evaluating the firm's capital structure. Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm's capital structure, Lewis has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures-A (30% debt ratio) and B (50% debt ratio)-that he would like to consider.
Source of capital Current (10% debt) A (30% debt) B (50% debt)
Long-term debt $1,000,000 $3,000,000 $5,000,000
Coupon interest rateb
9% 10% 12%
Common stock 100,000 shares 70,000 shares 40,000 shares
Required return on equity, ksc
12% 13% 18%
aThese structures are based on maintaining the firm's current level of $10,000,000 of total financing.
bInterest rate applicable to all debt.
cMarket-based return for the given level of risk.
Lewis expects the firm's earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.
A. Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the current and two alternative capital structures using the times interest earned and debt ratios.
B. Prepare a single EBIT-EPS graph showing the current and two alternative capital structures.
C. On the basis of the graph in part b, which capital structure will maximize McGraw's earnings per share (EPS) at its expected level of EBIT of $1,200,000? Why might this not be the best capital structure?
D. Using the zero-growth valuation model given in Equation 11.12, find the market value of McGraw's equity under each of the three capital structures at the $1,200,000 level of expected EBIT.
E. On the basis of your findings in parts c and d, which capital structure would you recommend? Why?
F. Find the Weighted Average Cost of Capital (WACC)
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