Capital Structure and Leverage

1. A company’s fixed operating costs are P500,000, its variable costs are P3.00 per unit, and the
product’s sales price is P4.00 per unit. What is the company’s breakeven point; that is, what unit
sales volume will its income equal its costs?

Answer
F
QBE =
PV
$500,000
QBE =
$4.00  $3.00
QBE = 500,000 units.

2. Jackson Trucking Company is in the process of setting its target capital structure. The CFO
believes that the optimal debt ratio is somewhere between 20% and 50%, and her staff compiled
the following projections for EPS and the stock price at various debt levels:
Debt Ratio Projected EPS Projected Stock Price
20% P3.20 P35.00
30 3.45 36.50
40 3.75 36.25
50 3.50 35.50

Assuming that the firm uses only debt and common equity, what is Jackson’s optimal capital
structure? At what debt ratio is the company’s WACC minimized

Answer
The optimal capital structure is that capital structure where WACC is minimized and stock price
is maximized. Because Jackson’s stock price is maximized at a 30% debt ratio, the firm’s
optimal capital structure is 30% debt and 70% equity. This is also the debt level where the firm’s
WACC is minimized.

3. Given the following information, calculate the expected value for Firm C’s EPS. Data for firms
A and B are as follows: E(EPSA) = %5.10, and σA = P3.61; E(EPSB) = P4.20, and σB = P2.96.

PROBABILITY
0.1 0.2 0.4 0.2 0.1
Firm A: EPSA (P1.50) P1.80 P5.10 P8.40 P11.70
Firm B: EPSB (1.20) 1.50 4.20 6.90 9.60
Firm C: EPSC (2.40) 1.35 5.10 8.85 12.60

a. You are given that σc = P4.11. Discuss the relative riskiness of the three firms’ earnings.

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 Answer
a. Expected EPS for Firm C:
E(EPSC) = 0.1(-P2.40) + 0.2(P1.35) + 0.4(P5.10) + 0.2(P8.85) + 0.1(P12.60)
= -P0.24 + P0.27 + P2.04 + P1.77 + P1.26 = P5.10.

b. According to the standard deviations of EPS, Firm B is the least risky, while C is the riskiest.
However, this analysis does not consider portfolio effects—if C’s earnings increase when
most other companies’ decline (that is, its beta is low), its apparent riskiness would be
reduced. Also, standard deviation is related to size, or scale, and to correct for scale we could
calculate a coefficient of variation (/mean):
E(EPS)  CV = /E(EPS)
A P5.10 P3.61 0.71
B 4.20 2.96 0.70
C 5.10 4.11 0.81

By this criterion, C is still the most risky.

4. Harley Motors has P10 million in assets, which were financed with P2 million of debt and P8
million of equity. Harley’s beta is currently 1.2, and its tax rate is 40%. Use the Hamada equation
to find Harley’s unlevered beta, bu.

Answer
From the Hamada equation, b = bU[1 + (1 – T)(D/E)], we can calculate bU as bU = b/[1 + (1 –
T)(D/E)].

bU = 1.2/[1 + (1 – 0.4)(P2,000,000/P8,000,000)]
bU = 1.2/[1 + 0.15]
bU = 1.0435.

5. Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on
debt. Each has P20 million in assets, has P4 million of EBIT, and is in the 40% federal-plus-state
tax bracket. Firm HL, however has a debt ratio (D/A) of 50% and pays 12% interest on its debt,
whereas LL has a 30% debt ratio and pays only 10% interest on its debt.
a. Calculate the rate of return on equity (ROE) for each firm.
b. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt ratio from
30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate
the new ROE for LL.

Answer
a. LL: D/TA = 30%.
EBIT P4,000,000
Interest (P6,000,000  0.10) 600,000
EBT P3,400,000
Tax (40%) 1,360,000
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 Net income P2,040,000

Return on equity = P2,040,000/P14,000,000 = 14.6%.

HL: D/TA = 50%.

EBIT P4,000,000
Interest (P10,000,000  0.12) 1,200,000
EBT P2,800,000
Tax (40%) 1,120,000
Net income P1,680,000

Return on equity = P1,680,000/P10,000,000 = 16.8%.

b. LL: D/TA = 60%.

EBIT P4,000,000
Interest (P12,000,000  0.15) 1,800,000
EBT P2,200,000
Tax (40%) 880,000
Net income P1,320,000

Return on equity = P1,320,000/P8,000,000 = 16.5%.

Although LL’s return on equity is higher than it was at the 30% leverage ratio, it is lower
than the 16.8% return of HL.

Initially, as leverage is increased, the return on equity also increases. But, the interest rate
rises when leverage is increased. Therefore, the return on equity will reach a maximum and
then decline.

6. The Weaver Watch Company sells watches for P25, the fixed costs are P140,000, and variable
costs are P15 per watch.
a. What is the firm’s gain or loss at sales of 8,000 watches? At 18,000 watches?
b. What is the breakeven point?
c. What would happen to the breakeven point if the selling price was raised to P31?
d. What would happen to the breakeven point if the selling price was raised to P31 but variable
costs rose to P23 a unit?

Answer
a. 8,000 units 18,000 units
Sales P200,000 P450,000
Fixed costs 140,000 140,000
Variable costs 120,000 270,000
Total costs P260,000 P410,000
Gain (loss) (P 60,000) P 40,000

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 F
b. QBE = = = 14,000 units.
PV

SBE = QBE(P) = (14,000)(P25) = P350,000.

c. If the selling price rises to P31, while the variable cost per unit remains fixed, P – V rises to
P16. The end result is that the breakeven point is lowered.

F
QBE = = = 8,750 units.
PV

SBE = QBE(P) = (8,750)(P31) = P271,250.

d. If the selling price rises to P31 and the variable cost per unit rises to P23, P – V falls to P8.
The end result is that the breakeven point increases.

F
QBE = = = 17,500 units.
P-V

SBE = QBE(P) = (17,500)(P31) = P542,500.

The breakeven point increases to 17,500 units because the contribution margin per each unit
sold has decreased.

7. The Neal Company wants to estimate next year’s return on equity (ROE) under different ratios.
Neal’s total assets are P14 million, it currently uses only common equity, and its federal-plus-
state tax rate is 40%. The CFO has estimated next year’s EBIT for three possible states of the
world: P4.2 million with a 0.2 probability, P2.8 million with a 0.5 probability, and P700,000 with
a 0.3 probability. Calculate Neal’s expected ROE, standard deviation, and coefficient of variation
for each of the following debt ratios; then evaluate the results:

Debt Ratio Interest Rate

0% -
10 9%
50 11
60 14

Answer
No leverage: Debt = 0; Equity = P14,000,000.
State Ps EBIT (EBIT – rdD)(1 – T) ROES PS(ROE) PS(ROES – RÔE)2
1 0.2 P4,200,000 P2,520,000 0.18 0.036 0.00113
2 0.5 2,800,000 1,680,000 0.12 0.060 0.00011
3 0.3 700,000 420,000 0.03 0.009 0.00169
RÔE = 0.105
Variance = 0.00293
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 Standard deviation = 0.054

RÔE = 10.5%.

2 = 0.00293.

 = 5.4%.

CV = /RÔE = 5.4%/10.5% = 0.514.

Leverage ratio = 10%: Debt = P1,400,000; Equity = P12,600,000; rd = 9%.

State Ps EBIT (EBIT – rdD)(1 – T) ROES PS(ROE) PS(ROES – RÔE)2
1 0.2 P4,200,000 P2,444,400 0.194 0.039 0.00138
2 0.5 2,800,000 1,604,400 0.127 0.064 0.00013
3 0.3 700,000 344,400 0.027 0.008 0.00212
RÔE = 0.111
Variance = 0.00363
Standard deviation = 0.060

RÔE = 11.1%.

2 = 0.00363.

 = 6%.

CV = 6%/11.1% = 0.541.

Leverage ratio = 50%: Debt = P7,000,000; Equity = P7,000,000; rd = 11%.

State Ps EBIT (EBIT – rdD)(1 – T) ROES PS(ROE) PS(ROES – RÔE)2
1 0.2 P4,200,000 P2,058,000 0.294 0.059 0.00450
2 0.5 2,800,000 1,218,000 0.174 0.087 0.00045
3 0.3 700,000 (42,000) (0.006) (0.002) 0.00675
RÔE = 0.144
Variance = 0.01170
Standard deviation = 0.108

RÔE = 14.4%.

2 = 0.01170.

 = 10.8%.

CV = 10.8%/14.4% = 0.750.

Leverage ratio = 60%: D = P8,400,000; E = P5,600,000; rd = 14%.

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 State Ps EBIT (EBIT – rdD)(1 – T) ROES PS(ROE) PS(ROES – RÔE)2
1 0.2 P4,200,000 P1,814,400 0.324 0.065 0.00699
2 0.5 2,800,000 974,400 0.174 0.087 0.00068
3 0.3 700,000 (285,600) (0.051) (0.015) 0.01060
RÔE = 0.137
Variance = 0.01827
Standard deviation = 0.135
RÔE = 13.7%.

2 = 0.01827.

 = 13.5%.

CV = 13.5%/13.7% = 0.985  0.99.

As leverage increases, the expected return on equity rises up to a point. But as the risk increases
with increased leverage, the cost of debt rises. So after the return on equity peaks, it then begins
to fall. As leverage increases, the measures of risk (both the standard deviation and the
coefficient of variation of the return on equity) rise with each increase in leverage.

8. Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital
structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should
use more debt. The risk-free rate, rRF, is 5%; the market risk premium RPM, is 6%; and the firm’s
tax rate is 40%. Currently, Cyclone’s cost of equity is 14%, which is determined by the CAPM.
What would be Cyclone’s estimated cost of equity if it changed its capital structure to 50% debt
and 50% equity?

Answer
Facts as given: Current capital structure: 25% debt, 75% equity; rRF = 5%; rM – rRF = 6%; T =
40%;
rs = 14%.

Step 1: Determine the firm’s current beta.

rs = rRF + (rM – rRF)b
14% = 5% + (6%)b
9% = 6%b
1.5 = b.

Step 2: Determine the firm’s unlevered beta, bU.

bU = bL/[1 + (1 – T)(D/E)]
= 1.5/[1 + (1 – 0.4)(0.25/0.75)]
= 1.5/1.20
= 1.25.

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 Step 3: Determine the firm’s beta under the new capital structure.
bL = bU[1 + (1 – T)(D/E)]
= 1.25[1 + (1 – 0.4)(0.5/0.5)]
= 1.25(1.6)
= 2.

Step 4: Determine the firm’s new cost of equity under the changed capital structure.
rs = rRF + (rM – rRF)b
= 5% + (6%)2
= 17%.
9. Tapley Inc. currently has assets of P5 million, has zero debt, is in the 40% federal-plus-state tax
rate bracket, has a net income of P1 million, and pays out 40% of its earnings as dividend. Net
income is expected to grow at a constant rate of 5% per year, 200,000 shares of stock are
outstanding, and the current WACC is 13.40%.

The company is considering a recapitalization where it will issue P1 million in debt and use the
proceeds to repurchase stock. Investment bankers have estimated that if the company goes through
with the recapitalization, its before-tax cost of debt will be 11% and its cost of equity will rise to
14.5%.
a. What is the stock’s current price per share (before the recapitalization)?
b. Assuming that the company maintains the same payout ratio, what will be its stock price
following the recapitalization?

Answer
a. The current dividend per share, D0, = P400,000/200,000 = P2.00. D1 = P2.00(1.05) =
P2.10. Therefore, P0 = D1/(rs – g) = P2.10/(0.134 – 0.05) = P25.00.

b. Step 1: Calculate EBIT before the recapitalization:

EBIT = P1,000,000/(1 – T) = P1,000,000/0.6 = P1,666,667.

Note: The firm is 100% equity financed, so there is no interest expense.

Step 2: Calculate net income after the recapitalization:

[P1,666,667 – 0.11(P1,000,000)]0.6 = P934,000.

Step 3: Calculate the number of shares outstanding after the recapitalization:

200,000 – (P1,000,000/P25) = 160,000 shares.

Step 4: Calculate D1 after the recapitalization:

D0 = 0.4(P934,000/160,000) = P2.335.

D1 = P2.335(1.05) = P2.45175.

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 Step 5: Calculate P0 after the recapitalization:
P0 = D1/(rs – g) = P2.45175/(0.145 – 0.05) = P25.8079  P25.81.

10. Currently, Bloom Flowers Inc. has a capital structure consisting of 20% debt and 80% equity.
Bloom’s debt currently has 8% yield to maturity. The risk-free rate (rRF) is 5%, and the market
risk premium (rM - rRF ) is 6%. Using the CAPM, Bloom estimates that its cost of equity is
currently 12.5%. The company has a 40% tax rate.
a. What is bloom’s current WACC?
b. What is the current beta on Bloom’s common stock?
c. What would Bloom’s beta be if the company had no debt in its capital structure? (That is,
what is Bloom’s unlevered beta, bu?)
Bloom’s financial staff is considering changing its capital structure to 40% debt and 60%
equity. If the company went ahead with the proposed change, the yield to maturity on the
company’s bonds would rise to 9.5%. the proposed change will have no effect on the
company’s tax rate.
d. What would be the company’s new cost of equity if it adopted the proposed change in
capital structure?
e. What would be the company’s new WACC if it adopted the proposed change in capital
structure?
f. Based on your answer to Part e, would you advise Bloom to adopt the proposed change in
capital structure? Explain.

Answer
a. Using the standard formula for the weighted average cost of capital, we find:
WACC = wdrd(1 – T) + wcrs
= (0.2)(8%)(1 – 0.4) + (0.8)(12.5%)
= 10.96%.

b. The firm's current levered beta at 20% debt can be found using the CAPM formula.
rs = rRF + (rM – rRF)b
12.5% = 5% + (6%)b
b = 1.25.

c. To ―unlever‖ the firm's beta, the Hamada equation is used.

bL = bU[1 + (1 – T)(D/E)]
1.25 = bU[1 + (1 – 0.4)(0.2/0.8)]
1.25 = bU(1.15)
bU = 1.086957.

d. To determine the firm’s new cost of common equity, one must find the firm’s new beta
under its new capital structure. Consequently, you must ―relever‖ the firm's beta using the
Hamada equation:
bL,40% = bU[1 + (1 – T)(D/E)]
bL,40% = 1.086957 [1 + (1 – 0.4)(0.4/0.6)]
bL,40% = 1.086957(1.4)

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 bU = 1.521739.

The firm's cost of equity, as stated in the problem, is derived using the CAPM equation.
rs = rRF + (rM – rRF)b
rs = 5% + (6%)1.521739
rs = 14.13%.

e. Again, the standard formula for the weighted average cost of capital is used. Remember,
the WACC is a marginal, after-tax cost of capital and hence the relevant before-tax cost of
debt is now 9.5% and the cost of equity is 14.13%.
WACC = wdrd(1 – T) + wcrs
= (0.4)(9.5%)(1 – 0.4) + (0.6)(14.13%)
= 10.76%.

f. The firm should be advised to proceed with the recapitalization as it causes the WACC to
decrease from 10.96% to 10.76%. As a result, the recapitalization would lead to an
increase in firm value.

11. ABC Corporation has a capital structure that consists of P20 million in debt and P40 million in
equity. The debt has a coupon rate of 10%, while the industry return on equity is 15%. ABC
Corporation is unsure of the state of the economy in the next year. The tax rate facing the
company is 40%.

State of the Economy BAD GOOD GREAT

EBIT P2,000,000 P5,000,000 P10,000,000
Probability 0.40 0.40 0.20

Given the information in the table, what is the expected earnings per share if the company has 1
million shares outstanding?

Answer:
Bad (P2,000,000 x 0.40) P 800,000
Good (P5,000,000 x 0.40) 2,000,000
Great (P10,000,000 x 0.20) 2,000,000
Expected EBIT P4,800,000
Less: Interest expense (P20,000,000 x 0.10) 2,000,000
EBT P2,800,000
Tax (40%) 1,120,000
Net income P1,680,000

Expected EPS = P1,680,000/1,000,000 P1.68

What is ABC’s standard deviation?

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 Answer
State Ps EBIT (EBIT – rdD)(1 – ROES PS(ROE) PS(ROES –
2
T) RÔE)
1 0.4 P2,000,000 P0 0.00 0.000 0.0000
2 0.4 5,000,000 1,800,000 0.045 0.018 0.0000036
3 0.2 10,000,000 4,800,000 0.12 0.024 0.0012168
RÔE = 0.042
Variance = 0.0012204
Standard deviation = 0.034934

What is ABC’s coefficient of variation?

Answer

CV = δ/EPS = 0.034934/1.68 = 0.020794

12. A firm has current earnings per share of P5 and a degree of total leverage of 4. What would be
the earnings per share if there is an increase of 10% in sales?

Answer
DTL = DFL x DOL

4 = % ΔEPS x %ΔEBIT
%ΔEBIT %Δ Sales

4 = %ΔEPS
%Δ Sales

4 = %ΔEPS
10%

%ΔEPS = 4(10%)
= 0.40

EPS = 5(1.40)

= 7.00

13. APMT, Inc. is considering purchasing a small firm in the same line of business. The purchase
would be financed by the sale of common stock or a bond issue. The financial manager needs
to evaluate how the two alternative financing plans will affect the earnings potential of the firm.
Total financing required is P5 million. The firm currently has P20,000,000 of 12 percent bonds
and 600,000 common shares outstanding. The firm can arrange financing of the P5 million
through a 15 percent bond issue or the sale of 100,000 shares of common stock. The firm’s
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 EBIT is P7,000,000. The firm has a 40 percent tax rate. What is the degree of financial leverage
if the firm uses bond to acquire the small firm?

Answer
7,000,000
DFL at base level EBIT = --------------------------- = 1.8182
(Bond Issue) 7,000,000 - 3,150,000

14. Rodel Inc. has sales of P5,000,000. The company’s fixed operating costs total P500,000 and its variable
costs equal 55 percent of sales, so the company’s current operating income is P1,750,000. The
company’s interest expense is P400,000.
a. What is the firm's DOL?
b. What is the firm's DFL?
c. What is the firm’s DTL?

Answer
a) DOL = CM/EBIT
CM = P5M x (1 – 55%) = P2.250M
DOL = P2.250M/P1.750M = 1.2857x = 1.29x

b) DFL = EBIT/EBT
EBT = P1,750K – P400K = P1,350K
DFL = P1,750K/P1,350K = 1.2962x = 1.30x

c) DTL = CM/EBT or DOL x DFL

= P2,250K/P1,350K = 1.6666x = 1.67x or
= 1.2857 x 1.2962 = 1.6666x = 1.67x

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