chapter 24 - answer

Solutions Manual

CHAPTER 24

ASSESSING LONG-TERM DEBT, EQUITY AND CAPITAL STRUCTURE

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. Capital structure is the composition of a firm’s financing, which consists of its permanent sources of capital.

2. The financial manager’s objective in making capital structure decisions is to find the financing mix that maximizes the market value of the firm. This structure is called the optimal capital structure.

3. Under idealized conditions with no income taxes, the traditional approach to capital structure suggests that there is an optimal capital structure which simultaneously maximizes the firm’s market value and minimizes its weighted average cost of capital.

Under idealized conditions with no income taxes, the Modigliani and Miller model implies that the total market value and cost of capital are independent of a firm’s capital structure.

Under idealized conditions with corporate income taxes, the Modigliani and Miller model concludes that leverage affects value, and that firms should be financed with virtually all debt.

Under relaxed assumptions, the contemporary approach suggests that there is an optimal range for the capital structure of the firm. If the firm finances outside this range, the value of the firm will decline.

4. Choosing an optimal or target capital structure involves tradeoff among opposing benefits and costs and requires the use of both analytical techniques and informed judgment.

5. A firm can analyze its capital structure by performing an EBIT – EPS analysis; assessing risk associated with various capital structures; computing debt management ratios and comparing them with industry standards; and seeking the opinion of lenders, investment analysts, and investment bankers. EBIT – EPS analysis is useful for evaluating the sensitivity of EPS to changes in EBIT under various financing plans.

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Chapter 24 Assessing Long-term Debt, Equity and Capital Structure

6. The indifference point is the EBIT level at which EPS is equal under alternate financing plans. This point may be found either graphically or mathematically.

7. EBIT – EPS analysis may be criticized because it does not directly consider the long-run financial consequences of financing alternatives and concentrates on earnings maximization rather than wealth maximization.

8. Capital structure decisions are tempered by such considerations as cash flow, market conditions, profitability and stability, control, management preferences, financial flexibility, and business risk.

II. Multiple Choice Questions

1. D 4. B 7. D 10. D2. D 5. B 8. C3. A 6. D 9. A

III. Problems

Problem 1

For the following problem, assume that:

kd = Cost of debt I = Interest ks = Cost of equity V = Market value of the firmka = Weighted average cost of capitalEBIT = Earnings before interest and taxes

(a) Substituting kd = 0.08 and I = P80,000 and solving for D, the market value of debt is:

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P80,000D

= P1,000,000

=0.08

P80,0000.08=D

Assessing Long-term Debt, Equity and Capital Structure Chapter 24

Substituting EBIT = P800,000, I = P80,000, and ks = 0.12, the market value of equity is:

Substituting D = P1,000,000 and S = P6,000,000, the total market value of the firm is:

(b) Substituting EBIT = P800,000 and V = P7,000,000, the weighted average cost of capital is:

Problem 2

(a) Substituting kd = 0.08 and I = P200,000 and solving for D, the market value of debt is:

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P800,000 − P80,0000.12

= P6,000,000

=S

P720,0000.12=

= P7,000,000

V = P1,000,000 + P6,000,000

= 0.1143 or 11.43%

P800,000P7,000,000=ka

P200,000D

= P2,500,000

=0.08

P200,0000.08=D


Substituting EBIT = P800,000, I = P200,000, and ks = 0.125, the market value of equity is:

Substituting D = P2,500,000 and S = P4,800,000, the total market value of the firm is:

(b) Substituting EBIT = P800,000 and V = P7,300,000, the weighted average cost of capital is:

(c) The market value of the firm (V) has increased and the weighted average cost of capital (ka) has decreased with the use of additional debt. Thus, the firm is operating in a world as viewed by the traditionalists.

Problem 3

(a) According to the MM approach, the market value of the firm remains unchanged at P7,000,000 with increased leverage.

(b) According to the MM approach, the weighted average cost of capital remains unchanged at 11.43 percent with increased leverage.

(c) Substituting V = P7,000,000 and D = P2,500,000 and solving for S, the market value of ordinary equity share outstanding is:

P7,000,000 = P2,500,000 + S

S = P7,000,000 − P2,500,000

= P4,500,000

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P800,000 − P200,0000.125

= P4,800,000

=S

P600,0000.125=

= P7,300,000

V = P2,500,000 + P4,800,000

= 0.1096 or 10.96%

P800,000P7,300,000=ka


Substituting EBIT = P800,000, I = P200,000, and S = P4,500,000, the cost of equity is:

Problem 4

(a) Since the firm has no debt, the market value of the firm is found by multiplying the ordinary equity share selling price per share by the number of shares outstanding:

S = (P25) (400,000)

= P10,000,000

(b) Substituting EBIT = P1,500,000 and S = P10,000,000, the cost of equity is:

Problem 5

(a) Weighted Average Costs of Capital Computation

Source of Capital A B

Debt (0.30 x 0.08) = 24% (0.60 x 0.10) = 6%Equity (0.70 x 0.14) = 9.8% (0.40 x 0.18) = 7.2%

Total 12.2% 13.2%

(b) Capital Structure A is less costly.

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= 0.1333 or 13.33%

P800,000 − P200,000P4,500,000=ks

= 0.1500 or 15.00%

P1,500,000P10,000,000=ks


Problem 6

(a) The value of Rocky Road Corporation with no leverage is:

(b) 1. The value of Rocky Road Corporation with P1,000,000 in debt is:

2. The total market value with P2,000,000 in debt is:

Due to the tax shelter, the firm is able to increase its value in a linear manner with more debt.

Problem 7

(a) The market value of the firm under each capital structure is:

Capital Structure Vu NTD FD V1

A P40,000,000 + P 600,000 − P 0 = P40,600,000B P40,000,000 + P1,200,000 − P 100,000 = P41,100,000C P40,000,000 + P2,400,000 − P 250,000 = P42,150,000D P40,000,000 + P3,600,000 − P 800,000 = P42,800,000E P40,000,000 + P4,200,000 − P2,000,000 = P42,200,000F P40,000,000 + P5,400,000 − P5,000,000 = P40,400,000

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= P3,300,000

(P750,000) (1− 0.34)0.15=

Value of the firm with no leverage

P495,0000.15=

=Value of the firm

with leverage P3,300,000 + (0.34) (P1,000,000)

= P3,640,000

=Value of the firm

with leverage P3,300,000 + (0.34) (P2,000,000)

= P3,980,000


Capital Structure D is preferred because it provides the greatest market value of the firm.

(b) The major problem in using the contemporary approach is estimating the various inputs. This approach is relatively easy to apply in theory but difficult to use in practice.

Problem 8

(a) Substituting I = P720,000 (0.09 x P8,000,000), the financial break-even point under Plan A is:

Plan A Fb = P720,000

Under Plan B, the firm does not have any fixed financial costs (interest or preferred share dividends). Thus the financial breakeven point under Plan B is:

Plan B Fb = P 0

(b) The EBIT – EPS indifference point is:

Cross multiplying:

(750) (0.66 EBIT* – P475.20) = (500) (0.66 EBIT*)495 EBIT* – P356,400 = 330 EBIT*

165 EBIT* = P356,400EBIT* = P2,160 (in thousands)

or P2,160,000

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(EBIT* – P720) (1 − 0.34) – P 0500

(EBIT* – P 0) (1 − 0.34) – P 0750=

=EPS (debt) EPS (ordinary equity share)

0.66 EBIT* – P475.20500

0.66 EBIT* 750=


(c) The EPS are calculated as follows:

Plan A:Debt

Plan B:Ordinary

Equity Share

EBIT P2,750,000 P2,750,000Less: Interest on new debt 720,000 0Earnings before taxes 2,030,000 2,750,000Less: Income taxes (34%) 690,200 935,000Net income P1,339,800 P1,815,000

Ordinary equity shares 500,000 750,000Earnings per share P2.68 P2.42

(d) Valdez Sporting Goods should adopt Plan A if it can be reasonably sure that the EBIT will not drop below the indifference point. Although Plan A results in a higher EPS than Plan B, debt financing involves greater risk than ordinary equity share financing.

Problem 9

(a) The interest on existing debt is P2,200,000 (0.11 x P20,000,000) and the interest on the new debt is P1,000,000 (0.10 x P10,000,000). Substituting I1 = P3,200,000, I2 = P2,200,000, PD = P525,000 (P5.25 x 100,000), T = 0.34, n1 = 2,000,000, and n2 = 2,500,000 (with thousands of pesos omitted), the EBIT – EPS indifference point is:

Cross multiplying:

(2,500) (0.66 EBIT* – P2,637) = (2,000) (0.66 EBIT* – P1,977)1,650 EBIT* – P6,592,500 = 1,320 EBIT* – 3,954,000

330 EBIT* = P2,638,500EBIT* = P7,995.455 (in thousands)

or P7,995,455

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(EBIT* – P3,200) (1 − 0.34) – P5252,000

(EBIT* – P2,200) (1 − 0.34) – P5252,500=

=EPS (debt) EPS (ordinary equity share)

0.66 EBIT* – P2,112 – P5252,000

0.66 EBIT* – P1,452 – P525 2,500=


(b) No. The difference point only identifies the level of EBIT where the EPS of two financing alternatives are equal. The risk associated with the financing alternatives is not reflected by the indifference point.

(c) Using the maximization of EPS as the criterion, ordinary equity share financing would be favored below P7,995,455 and debt financing above P7,995,455.

(d) Substituting ri = P7,995,455, ȓ = P9,500,000, and σ = P1,500,000, the z value is:

The area under the normal curve with a z = – 1.00 is 0.3413. The probability that EBIT will be below the indifference point of P7,995,455 is 0.1587 (0.5000 – 0.3413), or 15.87 percent.

(e) The EPS are calculated as follows:

Plan 1:Debt

Plan 2:Ordinary

Equity Share

EBIT P9,500,000 P9,500,000Less: Interest on existing debt 2,200,000 2,200,000 Interest on new debt 1,000,000 0Earnings before taxes 6,300,000 7,300,000Less: Income taxes (34%) 2,142,000 2,482,000Net income 4,158,000 4,818,000Less: Preferred share dividends 525,000 525,000Earnings available to ordinary

equity shareholders P3,633,000 P4,293,000

Ordinary equity shares 2,000,000 2,500,000Earnings per share P1.82 P1.72

(f) If the expected EBIT is P9,500,000, debt financing should be recommended because it provides a higher EPS than ordinary equity share financing with an acceptable level of risk. There is a 15.87 percent probability that the indifference point will not be reached.

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P7,995,455 – P9,500,000P1,500,000=z

– P1,504,545P1,500,000=

= – 1.00 (rounded)

chapter 24 - answer

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