PRACTICE QUESTIONS:

CAPITAL STRUCTURE
AND LEVERAGE
:BY
DR. SHAKEEL IQBAL AWAN
 Question # 1
Breakeven Analysis

A company’s fixed operating costs are $500,000,

its variable costs are $3.00 per unit, and the
product’s sales price is $4.00. What is the
company’s breakeven point; that is, at what unit
sales volume would its income equal its costs?

2
Solution: Question # 1
Breakeven Analysis

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

3
 Question # 2
Optimal Capital Structure
1) Jackson Trucking Company is in the process of setting its target capital structure. The CFO
believes the optimal debt ratio is somewhere between 20 and 50 percent, and her staff has
compiled the following projections for EPS and the stock price at various debt levels:

Debt Ratio Projected EPS Projected Stock Price

20% $3.20 $35.00
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?

4
 Solution: Question # 2
Optimal Capital Structure

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.

5
 Question # 3
Risk Analysis
a. 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 = $3.61; E(EPSB)
= $4.20, and σB = $2.96.

PROBABILITY
0.1 0.2 0.4 0.2 0.1
Firm A: EPSA ($1.50) $1.80 $5.10 $8.40 $11.70
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

b. You are given that σC = $4.11. Discuss the relative riskiness of the three firms’
earnings.

6
 Solution : Question # 3
Risk Analysis
a. Expected EPS for Firm C:
E(EPSC) = 0.1(-$2.40) + 0.2($1.35) + 0.4($5.10) + 0.2($8.85) + 0.1($12.60)
= -$0.24 + $0.27 + $2.04 + $1.77 + $1.26 = $5.10.

(Note that the table values and probabilities are dispersed in a symmetric manner such that
the answer to this problem could have been obtained by simple inspection.)

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 $5.10 $3.61 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.

7
 Question # 4
Unlevered Beta

Harley Motors has $10 million in assets,

which were financed with $2 million of
debt and $8 million in equity. Harley’s
beta is currently 1.2 and its tax rate is 40
percent. Use the Hamada equation to
find Harley’s unlevered beta, bU.

8
 Solution : Question # 4
Unlevered Beta
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)($2,000,000/$8,000,000)]
bU = 1.2/[1 + 0.15]
bU = 1.0435.

9
 Question # 5
Financial Leverage Effects

10
 Solution : Question # 5
Financial Leverage Effects
a. LL: D/TA = 30%.
EBIT $4,000,000
Interest ($6,000,000  0.10) 600,000
EBT $3,400,000
Tax (40%) 1,360,000
Net income $2,040,000

Return on equity = $2,040,000/$14,000,000 = 14.6%.

HL: D/TA = 50%.

EBIT $4,000,000
Interest ($10,000,000  0.12) 1,200,000
EBT $2,800,000
Tax (40%) 1,120,000
Net income $1,680,000

Return on equity = $1,680,000/$10,000,000 = 16.8%.

b. LL: D/TA = 60%.

EBIT $4,000,000
Interest ($12,000,000  0.15) 1,800,000
EBT $2,200,000
Tax (40%) 880,000
Net income $1,320,000

Return on equity = $1,320,000/$8,000,000 = 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 increas es. But, the interest rate
rises when leverage is increased. Therefore, the return on equity will reach a maximum and
then decline.

11
 Solution : Question # 5
Financial Leverage Effects
a. LL: D/TA = 30%.
EBIT $4,000,000
Interest ($6,000,000  0.10) 600,000
EBT $3,400,000
Tax (40%) 1,360,000
Net income $2,040,000

Return on equity = $2,040,000/$14,000,000 = 14.6%.

HL: D/TA = 50%.

EBIT $4,000,000
Interest ($10,000,000  0.12) 1,200,000
EBT $2,800,000
Tax (40%) 1,120,000
Net income $1,680,000

Return on equity = $1,680,000/$10,000,000 = 16.8%.

b. LL: D/TA = 60%.

EBIT $4,000,000
Interest ($12,000,000  0.15) 1,800,000
EBT $2,200,000
Tax (40%) 880,000
Net income $1,320,000

Return on equity = $1,320,000/$8,000,000 = 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.

12
 Question # 6
Breakeven Analysis

The Weaver Watch Company sells watches for $25; the fixed costs are
$140,000; and variable costs are $15 per watch.
• What is the firm’s gain or loss at sales of 8,000 watches? At 18,000
watches?
• What is the breakeven point?
• What would happen to the breakeven point if the selling price were raised
to $31? What is the significance of this analysis?
• What would happen to the breakeven point if the selling price were raised
to $31 but variable costs rose to $23 a unit?

13
 Solution : Question # 6
Breakeven Analysis
(a)

a. 8,000 units 18,000 units

Sales $200,000 $450,000
Fixed costs 140,000 140,000
Variable costs 120,000 270,000
Total costs $260,000 $410,000
Gain (loss) ($ 60,000) $ 40,000

F $140,000
b. QBE = = = 14,000 units.
PV $10

SBE = QBE(P) = (14,000)($25) = $350,000.

14
 Solution : Question # 6
Breakeven Analysis
(b)
c. If the selling price rises to $31, while the variable cost per unit remains fixed, P – V rises to
$16. The end result is that the breakeven point is lowered.

F $140,000
QBE = = = 8,750 units.
PV $16

SBE = QBE(P) = (8,750)($31) = $271,250.

The breakeven point drops to 8,750 units. The contribution margin per each unit sold has
been increased; thus the variability in the firm’s profit stream has been increased, but the
opportunity for magnified profits has also been increased.

d. If the selling price rises to $31 and the variable cost per unit rises to $23, P – V falls to $8. The end
result is that the breakeven point increases.

F $140,000
QBE = = = 17,500 units.
P-V $8

SBE = QBE(P) = (17,500)($31) = $542,500.

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

15
 Solution : Question # 6
Breakeven Analysis
(b)
c. If the selling price rises to $31, while the variable cost per unit remains fixed, P – V rises to
$16. The end result is that the breakeven point is lowered.

F $140,000
QBE = = = 8,750 units.
P  V $16

SBE = QBE(P) = (8,750)($31) = $271,250.

The breakeven point drops to 8,750 units. The contribution margin per each unit sold has
been increased; thus the variability in the firm’s profit stream has been increased, but the
opportunity for magnified profits has also been increased.

d. If the selling price rises to $31 and the variable cost per unit rises to $23, P – V falls to $8. The end
result is that the breakeven point increases.

F $140,000
QBE = = = 17,500 units.
P - V $8

SBE = QBE(P) = (17,500)($31) = $542,500.

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

16
 Question # 7
Operating Leverage and Breakeven Analysis
1) Olinde Electronics Inc. produces stereo components that sell at P = $100 per unit. Olinde’s
fixed costs are $200,000; variable costs are $50 per unit; 5,000 components are produced
and sold each year; EBIT is currently $50,000; and Olinde’s assets (all equity financed) are
$500,000. Olinde can change its production process by adding $400,000 to assets and
$50,000 to fixed operating costs.

This change would (1) reduce variable costs per unit by $10 and (2) increase output by
2,000 units, but (3) the sales price on all units would have to be lowered to $95 to permit
sales of the additional output. Olinde has tax loss carry-forwards that cause its tax rate to
be zero, it uses no debt, and its average cost of capital is 10 percent.

a. Should Olinde make the change?

b. Would Olinde’s breakeven point increase or decrease if it made the change?

17
 Solution : Question # 7
Operating Leverage and Breakeven Analysis
(a)

18
 Solution : Question # 7
Operating Leverage and Breakeven Analysis
(b)

19
 Solution : Question # 7
Operating Leverage and Breakeven Analysis
(b)

20
 Question # 8
Financial Leverage
1) Gentry Motors Inc., a producer of turbine generators, is in this situation:
EBIT = $4 million; tax rate = T = 35%; debt outstanding = D = $2 million; rd = 10%; rs = 15%;
shares of stock outstanding = N0 = 600,000; and book value per share = $10. Because Gentry’s
product market is stable and the company expects no growth, all earnings are paid out as
dividends. The debt consists of perpetual bonds.

a. What are Gentry’s earnings per share (EPS) and its price per share (P 0)?
b. What is Gentry’s weighted average cost of capital (WACC)?
c. Gentry can increase its debt by $8 million, to a total of $10 million, using the new debt to
buy back and retire some of its shares at the current price. Its interest rate on debt will be
12 percent (it will have to call and refund the old debt), and its cost of equity will rise from
15 to 17 percent. EBIT will remain constant. Should Gentry change its capital structure?
d. What is Gentry’s TIE coverage ratio under the original situation and under the conditions
in part c of this question?

21
Solution: Question # 8
Financial Leverage
(a)

22
Solution: Question # 8
Financial Leverage
(b)

23
Solution: Question # 8
Financial Leverage
(c)

24
 Solution: Question # 8
Financial Leverage
(d)

d)

25
 End of Lecture
Practice Questions Capital
Structure and Leverage

26