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Capital Structure and Leverage Assignment

This document contains 4 questions regarding capital structure and leverage for various companies. Question 1 involves calculating leverage metrics for DeSoto Tools before and after an expansion and constructing pro forma income statements with alternative financing options. Question 2 involves calculating valuation and WACC for Rogers Company under its current and an adjusted capital structure. Question 3 asks for the break-even quantity for Shapland Inc. Question 4 asks for the value of equity for Nichols Corporation after a recapitalization involving debt issuance and stock buyback.

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Faisal Farooqui
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79 views

Capital Structure and Leverage Assignment

This document contains 4 questions regarding capital structure and leverage for various companies. Question 1 involves calculating leverage metrics for DeSoto Tools before and after an expansion and constructing pro forma income statements with alternative financing options. Question 2 involves calculating valuation and WACC for Rogers Company under its current and an adjusted capital structure. Question 3 asks for the break-even quantity for Shapland Inc. Question 4 asks for the value of equity for Nichols Corporation after a recapitalization involving debt issuance and stock buyback.

Uploaded by

Faisal Farooqui
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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CAPITAL STRUCTURE AND LEVERAGE

ASSIGNMENT

1. DeSoto Tools Inc. is planning to expand production. The expansion will cost $4,400,000,
which can be financed either by bonds at an interest rate of 6 percent or by selling 88,000
shares of common stock at $50 per share. The current income statement before expansion is
as follows:
DeSoto Tools Inc. Income Statement 202X
Sales. $ 3,260,000
Variable costs 1,304,000
Fixed costs 824,000
Earnings before interest and taxes $ 1,132,000
Interest expense 640,000
Earnings before taxes $ 492,000 Taxes (@ 40%) 196,800
Earnings after taxes $ 295,200
Shares 340,000
Earnings per share $ .87
After the expansion, sales are expected to increase by $1,740,000. Variable costs will remain
at 40 percent of sales, and fixed costs will increase to $1,398,000. The tax rate is 40 percent.
a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree
of combined leverage before expansion. (For the degree of operating leverage, use the
formula: DOL = (S -TVC) / (S - TVC - FC). For the degree of combined leverage, use the
formula: DCL = (S - TVC) / (S - TVC - FC - I). These instructions apply throughout this
problem.) (Round your answers to 2 decimal places.)
b. Construct the income statement for the two alternative financing plans. (Input all amounts
as positive values. Round EPS to 2 decimal places.)
c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree
of combined leverage, after expansion. (Round your answers to 2 decimal places.)

Solution:
2. The Rogers Company is currently in this situation: (1) EBIT = $4.7 million; (2) tax rate, T =
40%; (3) value of debt, D = $2 million; (4) r d = 10%; (5) rs = 15%; (6) shares of stock
outstanding, n = 600,000; and stock price, P = $30.
The firm’s market is stable and it expects no growth, so all earnings are paid out as
dividends. The debt consists of perpetual bonds.
a. What is the total market value of the firm’s stock, S, and the firm’s total market value, V?
b. What is the firm’s weighted average cost of capital?
c. Suppose the firm can increase its debt so that its capital structure has 50% debt, based on
market values (it will issue debt and buy back stock). At this level of debt, its cost of equity
rises to 18.5% and its interest rate on all debt will rise to 12% (it will have to call and refund
the old debt). What is the WACC under this capital structure? What is the total value? How
much debt will it issue, and what is the stock price after the repurchase? How many shares
will remain outstanding after the repurchase?
3. Shapland Inc. has fixed operating costs of $500,000 and variable costs of $50 per unit. If it
sells the product for $75 per unit, what is the break-even quantity?
4. Nichols Corporation’s value of operations is equal to $500 million after a recapitalization
(the firm had no debt before the recap). It raised $200 million in new debt and used this to
buy back stock. Nichols had no short-term investments before or after the recap. After the
recap, wd = 40%. What is S (the value of equity after the recap)?

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