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Chapter 3. Leverage and Capital

structure
I. Questions:
3-1.Changes in sales cause changes in profits. Would the profit change associated with saleschanges
be larger or smaller if a firm increased its operating leverage? Explain your answer.

3-2 Would each of the following increase, decrease, or have an indeterminant effect on a firm’sbreak-
even point (unit sales)?
a. The sales price increases with no change in unit costs.
b. An increase in fixed costs is accompanied by a decrease in variable costs.
c. A new firm decides to use MACRS depreciation for both book and tax purposes rather
than the straight-line depreciation method.
d. Variable labor costs decline; other things are held constant.

3-3 Discuss the following statement: All else equal, firms with relatively stable sales are able to carry
relatively high debt ratios. Is the statement true or false? Why?

3-4 Which of the following would likely encourage a firm to increase the debt in its capital structure?
a. The corporate tax rate increases.
b. Due to market changes, the firm’s assets become less liquid.
c. Changes in the bankruptcy code make bankruptcy less costly to the firm.
d. The firm’s sales and earnings become more volatile.

3-5 .If a firm goes from zero debt to successively higher levels of debt, why would you expect its stock
price to rise first, then hit a peak, and then begin to decline?

3.6. What is business risk? What factors influence a firm’s business risk?

3.7 What is operating leverage, and how does it affect a firm’s business risk?
What is meant by the terms “financial leverage” and “financial risk”? How does financial risk differ
from business risk?

II. Problems

3.1 (14,1)A company’s fixed operating costs are $430,000, its variable costs
are $2.95 per unit, and the product’s sales price is $4.50. What is the company’s break-even
point; that is, at what unit sales volume will its income equal its costs?

3.2. (14.5). Firms HL and LL are identical except for their financial leverage ratios and the
interest rates they pay on debt. Each has $20 million in invested capital, has $4 million of
EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL,however, has a debt-to-
capital ratio of 50% and pays 12% interest on its debt, whereas LL has a 30% debt-to-
capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its
capital structure.
a. Calculate the return on equity (ROE) for each firm.
b. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt-to capital
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.

3.3. (14.6) The Warren Watch Company sells watches for $26, fixed costs are $155,000,
and variable costs are $13 per watch.
a. What is the firm’s gain or loss at sales of 9,000 watches? At 15,000 watches?
b. What is the break-even point? Illustrate by means of a chart.
c. What would happen to the break-even point if the selling price was raised to $33? What is the
significance of this analysis?
d. What would happen to the break-even point if the selling price was raised to $33 but variable costs
rose to $24 a unit?

3.4 (8Block n hirt). A company and B Company are the competition in the aftermarket for
auto supplies.

A B
Debt @ 10% 50,000 Debt @ 10% 100,000
Common Stock $ 10 par 100,000 Common Stock $ 10 50,000
par
Total $50,000 Total S150,000
Common Shares 10,000 Common Shares 5,000
a. Compute EPS if EBIT = $10,000, 15,000, 50,000 ( tax rate= 30%)
b. Explain relationship between EPS and level of EBIT
c. If the cost of the debt went up to 12% and all other facctors remained equal, what would be
B.E.P for EBIT

Capital structrure:

3.5.(14.8.HAMADA EQUATION ) Situational Software Co. (SSC) 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 4%; the market risk premium,
RPM, is 5%; and the firm’s tax rate is 40%. Currently, SSC’s cost of equity is 12%, which is determined
by the CAPM.
What would be SSC’s estimated cost of equity if it changed its capital structure to 40% debt and 60%
equity?

3.6 (14.11.RECAPITA LIZAT ION) Currently, Forever Flowers Inc. has a capital structure consisting
of 25% debt and 75% equity. Forever’s debt currently has a 7% yield to maturity. The risk-free rate
(rRF) is 6%, and the market risk premium (rM – rRF) is 7%. Using the CAPM, For ever estimates that its
cost of equity is currently 14.5%. The company has a 40% tax rate.

a. What is Forever’s current WACC?

b. What is the current beta on Forever’s common stock?
c. What would Forever’s beta be if the company had no debt in its capital structure?(That is, what is
Forever’s unlevered beta, bU?) Forever’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 10.5%. 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 Forever to adopt the proposed change in capital
structure? Explain.

3.7 (Ross- Break-Even EBIT) James Corporation is comparing two different capital
structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company
would have 160,000 shares of stock outstanding. Under Plan II, there would be 80,000
shares of stock outstanding and $2.8 million in debt outstanding.

The interest rate on the debt is 8 percent, and there are no taxes.
a. If EBIT is $350,000, which plan will result in the higher EPS?
b. If EBIT is $500,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?
3.8.(Ross). M&M and Stock Value In Problem 4, use M&M Proposition I to find the price
per share of equity under each of the two proposed plans. What is the value other firm?