Download 11 - JustAnswer

11. Assuming that all other factors remain unchanged, determine how a firm's
breakeven point is affected by each of the following:
a. The firm finds it necessary to reduce the price per unit because of competitive
conditions in the market.
A reduction in price per unit (P) reduces the contribution margin per unit (P - V) and
hence increases the breakeven output level (Qb).
b. The firm's direct labor costs increase as a result of a new labor contract.
An increase in direct labor costs increases variable cost per unit (V), reduces the
contribution margin per unit (P - V), and hence increases the breakeven output level
(Qb).
c. The Occupational Safety and Health Administration requires the firm to install new
ventilating equipment in its plant. (Assume that this action has no effect on worker
productivity.)
The installation of new ventilating equipment increases fixed costs (F) in the form of
depreciation on the equipment, and hence increases the breakeven output level
(Qb).
4. Albatross Airline’s fixed operating costs are $5.8 million, and its variable cost ratio is
0.20. The firm has$2 million in bonds outstanding with a coupon interest rate of 8
percent. Albatross has 30,000 shares of preferred stock outstanding, which pays a $2
annual dividend? There are 100,000 shares of common stock outstanding. Revenues for
the firm are $8 million, and the firm is in the 40 percent corporate income tax bracket.
a. Compute Albatross’ degree of operating leverage.
Sales - Variable cost
DOL =
EBIT
$8,000,000-$1,600,000
=
$600,000
= 10.67
b. Compute its degree of financial leverage.
EBIT
DFL =
EBIT-Interest
$600,000
=
$600,000-$160,000
= 1.36
c. Compute its degree of combined leverage and interpret this value.
DCL = DOL x DFL
= 10.67 x 1.36
= 14.55
The DCL shows that each one percent change in sales results in a 14.55 percent
change in EPS, in the same direction as the sales change.
8. A firm has sales of $10 million, variable costs of $5 million, EBIT of $2 million, and a
degree of total leverage of 3.0.
a. If the firm has not preferred stock, what are its annual interest charges?
DCL = (Sales - Variable cost)/[EBIT - Interest - Dp/(1-T)]
3.0 = ($10M - $5M) / ($2M - Interest)
Interest = $333,333
b. If the firm wishes to reduce its degree of total leverage to 2.5 by reducing interest
charges, what will be the new level of annual interest charges?
2.5 = ($10M - $5M) / ($2M - Interest)
Interest = $0
9. Fastron, Inc. expects sales of silicon chips to be $60 million this year. Because this is a
very capital-intensive business, fixed operating costs are $20 million. The variable cost
ratio is 40 percent. The firm’s debt obligations consist of a $4 million, 10 percent bank
loan and a $20 million bond issue with an 11 percent coupon rate. Fastron has 1 million
shares of common stock outstanding, and its marginal tax rate is 40 percent.
a. Compute Fastron’s degree of operating leverage.
Sales - Variable cost
DOL =
EBIT
$60,000,000-$24,000,000
=
$16,000,000
= 2.25
b. Compute Fastron’s degree of financial leverage.
EBIT
DFL =
EBIT-Interest
$16,000,000
=
$16,000,000-$2,600,000
= 1.19
c. Compute Fastron’s degree of combined leverage
DCL = DOL x DFL
= 2.25 x 1.19
= 2.69
d. Compute Fastron’s EPS if sales decline by 5 percent.
A sales decline to $57,000,000 is a 5 percent decline from $60,000,000
New EPS = $8.04 x (1 - (0.05 x 2.69)) = $6.96
6. What is the underlining objective of EBIT-EPS analysis?
Use of EBIT-EPS analysis can determine which financing alternative maximizes
EPS. However, it is possible that maximizing EPS results in such a high risk level
that the weighted cost of capital is not minimized, and therefore the value of the
firm is not maximized.
8. In practice what are the factors managers consider in setting a firm’s target capital
structure?
A firm should use more debt if it traditionally has been more profitable than the
average firm in the industry, or if its operating income is more stable than the
operating income of the average firm in the industry. If the opposite factors (i.e.,
less profitable and less stable) are true, the firm generally should use less debt. This
answer assumes that the average firm in the industry is operating at or near an
optimal capital structure.
4. Emco Products has a present capital structure consisting only of common stock (10
million shares). The company is planning a major expansion. At this time, the company is
undecided between the following two financial plans (assume a 40 percent marginal tax
rate):
Plan 1 (Equity financing). Under this plan, an additional 5 million shares of
common stock will be sold at $10 each.
Plan 2 (Debt financing). Under this plan, $50 million of 10 percent long term debt
will be sold.
One piece of information the company desires for its decision analysis is an EBIT-EPS
analysis.
a. Calculate the EBIT-EPS indifference point.
Interest under Debt Alternative = $50 (million) × 10% = $5 (million)
EPS (debt financing) = EPS (equity financing)
(EBIT - Interest)(1-Tax Rate)
(EBIT)(1-Tax Rate)

Number of CS Shares Outstanding Under Debt Alt. Number of CS Shares Outstanding Under Equity A
(EBIT - 5)(0.6) (EBIT)(0.6)

10
15
0.6 EBIT  3 0.6 EBIT

10
15
(10)(0.6 EBIT )  (15)(0.6 EBIT  3)
6EBIT = 9EBIT - 45
3 EBIT = 45
EBIT = $15
B.Graphically determine the EBIT-EPS indifference point
Hint: Use EBIT = $10 million and $25 million.
Please see the attached excel sheet for calculations
Indifference Point
$1.40
$1.20
EPS
$1.00
$0.80
Debt
Equity
$0.60
$0.40
$0.20
$0.00
$10
$15
$25
EBIT
c. What happens to the indifference point if the interest rate on debt increases and the
common stock sales price remains constant?
Indifference point moves to right, i.e., higher EBIT
d. What happens to the indifference point if the interest rate on debt remains constant and
the common stock sales prices increases?
Indifference point moves to right, i.e., higher EBIT.
5. Morton Industries is considering opening a new subsidiary in Boston, to be operated as
a separate company. The company’s financial analysts expect the new facility’s average
EBIT level to be $6 million per year. At this time, the company is considering the
following two financing plans (use a 40 percent marginal tax rate in your analysis):
Plan 1 (Equity Financing). Under this plan, $2 million common shares will be
sold at $10
each.
Plan 2 (Debt equity financing). Under this plan, $10 million of 12 percent longterm debt
and 1 million common shares at $10 each will be sold.
a. Calculate the EBIT-EPS indifference point.
EPS (Plan 1) = EPS (Plan 2)
[(EBIT - 0)(1 - .4)]/2 = [(EBIT - 1.2)(1 - .4)]/1
EBIT* = $2.4 million
b. Calculate the expected EPS for both financing plans.
EBIT
I
EBT
Plan 1
Plan 2
$6.0
$6.0
0
1.2
$6.0
$4.8
T @ 40%
2.4
1.92
EAT
$3.6
$2.88
2.0
1.0
Shares Outstanding
EPS
$1.80
$2.88
c. What factors should the company consider in deciding which financing plan to adopt?
The factors the company should consider include the following:
1. The plan's effect on the company's stock price (difficult to determine in practice).
2. The capital structure of the parent company.
3. The probability distribution of expected EBIT.
d. Which plan do you recommend the company adopt?
Adopt plan 2 if the company can be reasonably sure that EBIT will not drop too much
in a recession. Otherwise, plan 1 appears better.
e. Suppose Morton adopts Plan 2, and the Boston facility initially operates at an annual
EBIT level of $6 million. What is the times interest earned ratio?
T.I.E. = (EBIT/I) = (6.0/1.2) = 5 times
Note: This calculation assumes no short-term debt, either permanent or seasonal.
6. Moon and Chittenden are considering a new Internet venture to sell used textbooks.
The project requires $300,000 in financing. Two alternatives have been proposed.
Plan 1 (Common equity financing). Sell 30, 000 shares of stock at a net price of
$10 per
share.
Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a
net price
of $10 per share and $150,000 of long-term debt at a pretax interest rate of
12 percent.
Assume the corporate tax rate is 40 percent.
a. Compute the indifference level of EBIT between these two alternatives
Plan A
Debt= $0
Equity= $300,000
# of shares= 30,000
Interest rate= 12.00%
Interest expense= $0.00
Plan B
Debt= $150,000
Equity= $150,000
# of shares= 15,000
Interest rate= 12.00%
Interest expense= $18,000 =12.% x $150,000.
EPS = (EBIT - Interest)x (1-Tax rate) / # of shares
EPS
Plan A : (EBIT-0) (1-0.4)/30000
Plan B : (EBIT-18000) (1-0.4)/15000
For point of indifference EPS under two plans should be eaual
or
(EBIT-0) (1-0.4)/30000 = (EBIT-18000) (1-0.4)/15000
Solving for EBIT:
EBIT= $36,000
Answer: EBIT= $36,000
b. If the firm’s EBIT next year has an expected value of $25,000, which plan would you
recommend assuming maximizing EPS is a valid objective?
Below the indifference point, the plan with lower debt is better
Hence opt for Plan A as it would give a higher EPS
Check:
EBIT= $25,000
Plan A
Debt $0
Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . . . . . 25,000
Less Interest expense @ 12.00% 0 =12.% x $.
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Less Taxes @ 40% 10,000 =40.% x $25,000.
Net Income= 15,000
Number of shares= 30,000
EPS= $0.500 =$15,000. / 30,000.
Plan B
Debt $150,000
Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . . . . . 25,000
Less Interest expense @ 12.00% 18,000 =12.% x $150,000.
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Less Taxes @ 40% 2,800 =40.% x $7,000.
Net Income= 4,200
Number of shares= 15,000
EPS= $0.280 =$4,200. / 15,000.