472 Part 5 Capital Structure and Dividend Policy

Assuming that EBIT equals 10 percent of sales, calculate earnings per share (EPS) under
both the debt financing and the stock financing alternatives at each possible level of
sales. Then calculate expected EPS and EPS under both debt and stock financing
alternatives. Also, calculate the debt ratio and the times-interest-earned (TIE) ratio at
the expected sales level under each alternative. The old debt will remain outstanding.
Which financing method do you recommend?

COMPREHENSIVE/SPREADSHEET
PROBLEM

14-14 WACC and optimal capital structure Elliott Athletics is trying to determine its optimal
capital structure, which now consists of only debt and common equity. The firm does not
currently use preferred stock in its capital structure, and it does not plan to do so in the
future. Its treasury staff has consulted with investment bankers and, on the basis of those
discussions, has created the following table showing its debt cost at different levels:
Debt-to- Equity-to- Before-Tax
Assets Ratio Assets Ratio Debt-to-Equity Bond Cost of
(wd) (wc) Ratio (D/E) Rating Debt (rd)

0.0 1.0 0.00 A 7.0%

0.2 0.8 0.25 BBB 8.0
0.4 0.6 0.67 BB 10.0
0.6 0.4 1.50 C 12.0
0.8 0.2 4.00 D 15.0

Elliott uses the CAPM to estimate its cost of common equity, rs, and estimates that the
risk-free rate is 5 percent, the market risk premium is 6 percent, and its tax rate is 40 per-
cent. Elliott estimates that if it had no debt, its “unlevered” beta, bU, would be 1.2.
a. What is the firm’s optimal capital structure, and what would be its WACC at the
optimal capital structure?
b. If Elliott’s managers anticipate that the company’s business risk will increase in the
future, what effect would this increase likely have on its target capital structure?
c. If Congress were to dramatically increase the corporate tax rate, what effect would
this increase likely have on Elliott’s target capital structure?
d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus
(1) the debt/assets ratio and (2) the debt/equity ratio.

Integrated Case
Campus Deli Inc.

14-15 Optimal capital structure Assume that you have just been hired as business manager of Campus Deli (CD),
which is located adjacent to the campus. Sales were $1,100,000 last year; variable costs were 60 percent of
sales; and fixed costs were $40,000. Therefore, EBIT totaled $400,000. Because the university’s enrollment is
capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD pays out all
earnings as dividends. Assets are $2 million, and 80,000 shares are outstanding. The management group owns
about 50 percent of the stock, which is traded in the over-the-counter market.
 Chapter 14 Capital Structure and Leverage 473

CD currently has no debt—it is an all-equity firm—and its 80,000 shares outstanding sell at a price of $25
per share, which is also the book value. The firm’s federal-plus-state tax rate is 40 percent. On the basis of
statements made in your finance text, you believe that CD’s shareholders would be better off if some debt
financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea, but
to provide support for the suggestion.
In today’s market, the risk-free rate, rRF, is 6 percent and the market risk premium, RPM, is 6 percent.
CD’s unlevered beta, bU, is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 12 percent.
If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repur-
chase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-
food companies similar to CD. You plan to complete your report by asking and then answering the following
questions.
a. (1) What is business risk? What factors influence a firm’s business risk?
(2) What is operating leverage, and how does it affect a firm’s business risk?
b. (1) What is meant by the terms “financial leverage” and “financial risk”?
(2) How does financial risk differ from business risk?
c. Now, to develop an example that can be presented to CD’s management as an illustration, consider two
hypothetical firms, Firm U, with zero debt financing, and Firm L, with $10,000 of 12 percent debt. Both
firms have $20,000 in total assets and a 40 percent federal-plus-state tax rate, and they have the following
EBIT probability distribution for next year:

Probability EBIT

0.25 $2,000
0.50 3,000
0.25 4,000

(1) Complete the partial income statements and the firms’ ratios in Table IC14-1.
(2) Be prepared to discuss each entry in the table and to explain how this example illustrates the effect of
financial leverage on expected rate of return and risk.
d. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at
different debt levels (in thousands of dollars):

Amount D/A D/E Bond

Borrowed Ratio Ratio Rating rd

$ 0 0 0 — —
250 0.125 0.1429 AA 8.0%
500 0.250 0.3333 A 9.0
750 0.375 0.6000 BBB 11.5
1,000 0.500 1.0000 BB 14.0

Now consider the optimal capital structure for CD.

(1) To begin, define the terms “optimal capital structure” and “target capital structure.”
(2) Why does CD’s bond rating and cost of debt depend on the amount of money borrowed?
(3) Assume that shares could be repurchased at the current market price of $25 per share. Calculate CD’s
expected EPS and TIE at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000. How many
shares would remain after recapitalization under each scenario?
(4) Using the Hamada equation, what is the cost of equity if CD recapitalizes with $250,000 of debt?
$500,000? $750,000? $1,000,000?
(5) Considering only the levels of debt discussed, what is the capital structure that minimizes CD’s
WACC?
(6) What would be the new stock price if CD recapitalizes with $250,000 of debt? $500,000? $750,000?
$1,000,000? Recall that the payout ratio is 100 percent, so g  0.
(7) Is EPS maximized at the debt level that maximizes share price? Why or why not?
474 Part 5 Capital Structure and Dividend Policy

(8) Considering only the levels of debt discussed, what is CD’s optimal capital structure?
(9) What is the WACC at the optimal capital structure?
e. Suppose you discovered that CD had more business risk than you originally estimated. Describe how this
would affect the analysis. What if the firm had less business risk than originally estimated?
f. What are some factors a manager should consider when establishing his or her firm’s target capital
structure?
g. Put labels on Figure IC14-1, and then discuss the graph as you might use it to explain to your boss why
CD might want to use some debt.
h. How does the existence of asymmetric information and signaling affect capital structure?

TA B L E I C 1 4 - 1 Income Statements and Ratios

Firm U Firm L

Assets $20,000 $20,000 $20,000 $20,000 $20,000 $20,000

Equity $20,000 $20,000 $20,000 $10,000 $10,000 $10,000

Probability 0.25 0.50 0.25 0.25 0.50 0.25

Sales $ 6,000 $ 9,000 $12,000 $ 6,000 $ 9,000 $12,000
Operating costs 4,000 6,000 8,000 4,000 6,000 8,000
Earnings before interest and taxes $ 2,000 $ 3,000 $ 4,000 $ 2,000 $ 3,000 $ 4,000
Interest (12%) 0 0 0 1,200 1,200
Earnings before taxes $ 2,000 $ 3,000 $ 4,000 $ 800 $ $ 2,800
Taxes (40%) 800 1,200 1,600 320 1,120
Net income $ 1,200 $ 1,800 $ 2,400 $ 480 $ $ 1,680
Basic earning power
(BEP  EBIT/Assets) 10.0% 15.0% 20.0% 10.0% % 20.0%
ROE 6.0% 9.0% 12.0% 4.8% % 16.8%
TIE    1.7  3.3
Expected basic earning power 15.0% %
Expected ROE 9.0% 10.8%
Expected TIE  2.5
BEP 3.5% %
ROE 2.1% 4.2%
TIE 0 0.6