CHAPTER 14

CAPITAL STRUCTURE AND LEVERAGE

FOCUS
Capital structure can influence the value of a firm. Our focus is on understanding why that's true and
what we can and can't do with the knowledge. The ideas are developed through a detailed illustration
that shows the performance and risk implications of financial leverage. Later in the chapter we explore
the theoretical approach to the same issue and see that the conclusions reached are similar. Along the
way we examine the concept of operating leverage and see how it interacts with financial leverage.
PEDAGOGY
The ideas behind capital structure and leverage are taught on two levels, the practical and the
theoretical. A practical understanding is developed using an example illustrating how leverage helps
recorded financial performance if the firm is doing well, but hurts it if operating results are poor. We
then describe how this effect influences risk-averse investors in their quest for returns.
The pedagogical challenge of capital structure is presenting the MM theory in a way the average
person can understand. The theory's math is difficult and its notation is unusual, creating two factors
that combine to bewilder most students immediately. Nevertheless, the theory is an important pillar in
the structure of finance, and should be at least appreciated by anyone seriously in the field.
The presentation of the subject is one of the defining features of this book. The ideas are developed
slowly, beginning with notation. Students are brought to an appreciation of what MM accomplished and
why it's important without advanced mathematics. At the end they can hold their own in a discussion of
the independence theory, arbitrage, and the effects of taxes and bankruptcy costs. Their understanding
is graphic and intuitive rather than mathematically rigorous, but it's all they'll ever need.
TEACHING OBJECTIVES
Students should gain an understanding of the interrelations among capital structure, financial results,
stock market prices and risk. They should also be able to quantify and roughly measure the risk and
performance implications of policy decisions regarding capital and cost structure.
OUTLINE
I

BACKGROUND
Terms are defined and the idea that capital structure can influence financial performance is
introduced.
A. The Central Issue
Can capital structure influence stock price and the market value of the firm? Further, is there an
optimal structure that maximizes value?
B. Risk in the Context of Leverage
Redefining risk as variation in EBIT and EPS.
C. Leverage and Risk - Two Kinds of Each
Operating and financial leverage, business and financial risk. Understanding the nature of each.

II. FINANCIAL LEVERAGE

A. The Effect of Financial Leverage
How financial leverage amplifies performance as measured by ROE and EPS - developed
through a detailed illustration. When leverage helps and when it hurts.
B. Financial Leverage and Financial Risk
Tying leverage to the notion of risk as variation in performance.
C. Putting the Ideas Together - The Effect on Stock Price
How investors react to performance variations and the effect on stock prices. The practical
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Capital Structure and Leverage

difficulty of finding an optimal capital structure.
D. The Degree of Financial Leverage (DFL) - A Measurement
The DFL concept. Using DFL to predict results and measure risk.
E. EBIT-EPS Analysis
Using leverage concepts to determine an appropriate capital structure given management's
expectations about EBIT.

III. OPERATING LEVERAGE

A. Terminology and Definitions
Cost structure - fixed and variable, defining operating leverage as the use of fixed costs.
B. Breakeven Analysis
The breakeven technique graphically and algebraically
C. The Effect of Operating Leverage
Using breakeven concepts to understand how operating leverage affects EBIT when volume
changes.
D. The Degree of Operating Leverage (DOL) - A Measurement
The DOL concept. Using DOL to predict results and measure risk.
E. Comparing Operating and Financial Leverage
A detailed comparison of the concepts showing similarities and differences.
F. The Compounding Effect of Operating and Financial Leverage
The effect of the two leverages is multiplicative and acting together can make a company very
risky.
The Degree of Total Leverage (DTL) concept.
IV. CAPITAL STRUCTURE THEORY
Formal financial theory approaches the capital structure issue differently but arrives at basically the
same result.
A. Background - The Value of the Firm
Understanding the theory's notation
B. The Early Theory by Modigliani and Miller
The basic MM model, its restrictive assumptions, and its results.
C. Relaxing the Assumptions - More Insights
The effect of including taxes and bankruptcy costs.
The MM approach arrives at the same result as the intuitive approach for somewhat different
reasons.
D. An Insight into Mergers and Acquisitions
The value added by financial leverage as a justification for paying premiums in acquisitions.
QUESTIONS
1.
The user of leverage might be thought of as taking advantage of the provider. Between
stockholders and bondholders, who is the user and who is the provider? Give a word explanation or
illustration that might support this view. What does the used party get in return?
ANSWER: Stockholders use leverage provided by bondholders. The stockholders, through
management, undertake projects using their own and bondholders money. The rewards of success
accrue mainly to stockholders, while the penalty for total failure is shared by both. This seeming
unfairness is the sense in which the user of leverage takes advantage of the provider.
However, bondholders are protected against moderate failure, which mainly hurts stockholders. This
is because interest payments must be made regardless of profitability.

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This safety under a wide range of poor performance short of disaster is what bondholders get in return
for providing leverage.
2.
The central issue underlying the study of leverage is whether or not it influences stock price and
whether there's an optimal structure. But the whole idea seems kind of fuzzy and uncertain. Why are
people so interested? (Hint: Think of management's goals and of the world of mergers.)
ANSWER: A great deal of money can be made very quickly if a change in leverage can have an
immediate and substantial impact on stock price. In merger situations, acquiring firms often borrow the
money to purchase firms being acquired. If the resulting increase in leverage of the combined
organization has a positive effect on stock price, the stockholders of both companies can get rich
virtually overnight.
3.

Relate business and financial risk as defined in this chapter to the risks described in Chapter 9.

ANSWER: The risks discussed in this chapter relate to variations in a firm's financial results. Business
risk is variation in EBIT. Financial risk is the increase in variation found between EBIT and EPS and
ROE if financial leverage is present. In other words, these risks are found within the firm's financial
statements.
The concepts in Chapter 9 were broader in that they addressed an investor's return. That return can
be influenced by recorded financial results as well as by other things that don't show up on a company's
books. For example, an economic recession depresses stock prices and therefore investor returns, but
may not influence profitability as seen in EBIT, ROE or EPS.
The risks in Chapter 9 include the risks discussed here.
4.

Why are ROE and EPS such important measures of performance to investors?

ANSWER: ROE is an indication of the total performance of a company including both operating and
financing issues. Since people invest only for money, the return on what's invested is of fundamental
importance. EPS taken along with stock price gives an indication of the same thing, just how much is a
firm making relative to the price of a share? EPS is also important because it tends to drive stock price
through the P/E ratio. Hence, it can be an indication of future price appreciation.
5.
Both business risk and financial risk would exist with or without either type of leverage.
Leverage just makes them more significant. Are these statements true or false? Explain.
ANSWER: False. Business risk is variation in EBIT. It is increased but not caused by operating
leverage. Some business risk exists in virtually all companies even in the complete absence of leverage.
However, financial risk is the additional variation in EPS over that of EBIT that comes as a result of
debt (financial leverage). Without financial leverage there is no financial risk.
6.
Briefly explain the pros and cons of financial leverage. In other words, what are its benefits,
and what are the costs that come along with those benefits?
ANSWER: Financial leverage makes good results measured in terms of EPS and ROE better. Hence in
good times it can enhance financial performance and thereby tends to increase stock price. However, it
can also exaggerate poor performance making a moderately poor showing in bad times much worse.
Leverage adds to the variability of financial performance, which is the essence of risk. Hence financial
leverage adds risk, which tends to depress stock price. This increased risk is the cost of leverage.
7.
Explain in words the ROCE test for the advisability of adding leverage. That is, what is the test
really telling us? When will it indicate a company is doing the wrong thing?

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ANSWER: The ROCE test measures the firm's operating ability to earn a return on invested money
against the cost of borrowing. If the ROCE is higher than the cost of borrowed funds (both after tax) the
firm will profit to the extent of the difference on whatever money it borrows. However, leverage adds
risk, and the ROCE doesn't test for that. Hence if borrowing is already high, it may be unwise to borrow
more even if the ROCE is above the cost of debt.
8.
The risk added by financing is small and insignificant relative to the inherent risk in most
businesses. Is that statement true or false? Discuss.
ANSWER: The statement is generally true in good times if, in addition, the use of leverage is low or
moderate. However, it is false when debt levels are high. Then debt can create financial risk that
exceeds business risk several times over.
9.
Describe generally how leverage affects stock prices. What forces are at work, driven by what
effects?
ANSWER: If business is good and the ROCE exceeds the after-tax cost of capital, additional leverage
enhances ROE and EPS. These measures are watched by investors and the improvement can have a
positive effect on stock price. At the same time, however, increased leverage makes those measures
more volatile in response to changes in the business's operating results. That implies a riskier business.
Risk levels are also watched by investors and have a negative impact on price. Which effect dominates
depends on how much leverage exists and the current business climate.
10.
Explain the difference between a fixed and a variable cost. How do these concepts change as
the time horizon lengthens? In other words, are the same things fixed over a 5-year planning period that
are fixed in a typical 1-year period? What about a 10-year period? What's the relevant period when
we're talking about operating leverage?
ANSWER: A fixed cost remains constant when production levels change. A variable cost increases or
decreases in direct proportion to changes in production. The longer the planning period the more things
are variable. For example the costs associated with a factory are fixed in the 1-year time frame. Over a
10-year period, however, a new factory can be built so the costs associated with it can be considered
variable.
The discussion of operating leverage is made in the context of a relatively short period of time.
Hence only direct inputs are variable.
11.
Why do labor-intensive processes involve less operating leverage than automated processes?
What fixed costs are associated with automation? Why can't those costs be eliminated by just selling
the machinery?
ANSWER: High operating leverage implies a preponderance of fixed cost. Labor isn't a fixed cost,
because people can be fired if business turns down. The main fixed cost associated with automation is
depreciation associated with the equipment. If the equipment is leased, the payments can be fixed if the
lease can't be broken. If the equipment is acquired with borrowed money, the interest on the loan is a
fixed cost. Idle machinery can be sold, but generally at a big loss. If the equipment is highly
specialized, there may be no market for it.
12.

Explain the idea of breakeven analysis in a brief paragraph.

ANSWER: Breakeven analysis finds the production and sales level required for the company to just
survive. At the breakeven volume, all costs are covered by revenue, but nothing is left over for profit.
The firm just "breaks even" in terms of profit and loss.

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13.
Describe the concept of the breakeven point in words by using the concept of contribution and
fixed costs. (Short answer.)
ANSWER: Each unit sold contributes the difference between price and variable cost to profit and
overhead. This amount is called the "contribution". At the breakeven point the total contribution from
all units sold just equals the firm's fixed costs.
14.

Summarize the effect of operating leverage on EBIT.

ANSWER: More operating leverage enhances EBIT at points above breakeven, but makes it worse
when operating below breakeven. Hence, it makes EBIT more volatile with changes in volume.
15.
The Braithwaite Tool Co. is considering a major modernization and automation of its plant
using borrowed funds. Fully discuss a serious financial negative that could result from the project.
ANSWER: The automation of the plant will make Braithwaite more capital intensive, add fixed costs,
and increase operating leverage. This will increase the volatility of EBIT as the level of sales changes.
By financing the project with borrowed money, the firm will add debt to its capital structure increasing
financial leverage. This makes EPS and ROE more volatile as EBIT changes.
The net result of these effects is multiplicative. Therefore, changes in sales may produce very large
changes in EPS and ROE after the project is implemented. This is likely to make the company more
risky in the eyes of investors and may have a detrimental effect on its stock price.
16.
Explain the idea of bankruptcy costs. Why are they important to investors? When do investors
start to worry about them?
ANSWER: Bankruptcy costs are the expenses incurred as a result of the administration of a firm's
failure. They are not losses associated with the business deterioration that causes the bankruptcy.
Rather they're the costs of the legal and administrative system and the loss incurred if assets need to be
sold cheaply. Bankruptcy costs are important to investors because they represent potential investment
losses. When times are good and the firm's debt level is relatively low, investors don't think much about
bankruptcy costs. They start to worry, however, when failure looks possible. They become especially
concerned when debt levels are high due to financial risk.
17.
Briefly describe the result of MM's original restrictive model. Why was it important in spite of
its serious restrictions?
ANSWER: MM's original model implied that the firm's value is independent of capital structure.
Although this view was already held by many others, MM described a logical way in which the
behavior of investors could make it happen. The theory showed that the effect of capital structure on
price and value is due to market imperfections like taxes and bankruptcy costs rather than to the basic
interaction between investors and companies.
18.
Briefly summarize the operating income argument that was supported by the original MM
result.
ANSWER: A firm's value is nothing more than the present value of its expected future income stream.
If expected income doesn't change, a rational market will hold the firm's total value constant regardless
of how the income is divided between debt and equity investors. Essentially the argument says that you
can't make something out of nothing. I.e., you can't create additional value out of a fixed income stream
by changing the way it's divided between debt and equity.

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19.
Outline the arbitrage process proposed by MM that supports the operating income argument.
What is the arbitrage between?
ANSWER: If increasing a firm's use of leverage created value, stockholders could profit by selling its
appreciated shares, borrowing money, and buying the unappreciated shares of a similar but unleveraged
firm. This would put downward pressure on the price of the leveraged firm and upward pressure on the
price of the unleveraged firm driving the two together. (Actually, keeping them from being different.)
The arbitrage is between stocks of leveraged and unleveraged firms.
20.

Explain in words how the tax system favors debt financing.

ANSWER: Payments to investors are either interest on debt or dividends on equity. Interest payments
are tax deductible, while dividends are not. To the extent income is paid in interest rather than as a
dividend, it generates a tax savings. That savings is kept by the company without affecting investors.
Hence it's cheaper to pay a debt investor than to pay the same amount to an equity investor. The
government effectively splits the bill for debt funds.
21.

In a short paragraph, describe the result of adding taxes to the MM model.

ANSWER: When taxes are added to the MM model, an annual tax savings equal to the tax rate times
the firm's total debt is created. The present value of the perpetuity of that stream of savings is an
addition to the value of the firm. This value increment increases steadily as more debt is added. It
belongs entirely to stockholders, since bondholder returns are fixed. Therefore, in the absence of other
refinements, the MM model with taxes implies that the firm should borrow as much as possible right up
to 100% of capital.
22.
In another short paragraph, describe the effect of adding bankruptcy costs to the MM model
with taxes.
ANSWER: Including bankruptcy costs in the MM model mitigates the value enhancing effect of taxes
by recognizing that more leverage increases risk. Since risk lowers value through its effect on the
required returns of equity investors, it offsets the benefit of the tax shield associated with more debt.
The two effects taken together mean that as leverage is added, value increases, reaches a maximum, and
then decreases
23.
Compare the implications of the MM model with taxes and bankruptcy costs to the things we
discovered by studying the Arizona Hot Air Balloon Corporation.
ANSWER: The bottom line is about the same. Adding debt to an unleveraged firm can initially
increase value and stock price, but eventually detracts from both. This means an optimal point must
exist for every firm with respect to the amount of leverage it uses. Neither approach tells us how to find
the optimum.
The reasons for the model's conclusions are somewhat different. The MM model bases the beneficial
effect of leverage on the favorable tax treatment of interest. The intuitive approach, on the other hand,
is based on the idea that a profit is available if a firm can earn more using borrowed money than it pays
for that use.
Both approaches conclude that a little leverage is good, but a lot is generally bad.

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BUSINESS ANALYSIS
1.
The Armageddon Corp is in big trouble. Sales are down and profits are off. On top of that, the
firm's credit rating has been reduced so it's facing very high interest rates on anything it borrows in the
future. Current long-term borrowing represents 60% of capital but at fixed interest rates, so it won't be
affected.
The firm's major stockholder, the Apocalypse Group, has scheduled a conference with management
to discuss the company's problems. Everyone is very nervous about this conference, and the executive
team is meeting to decide what to tell Apocalypse.
Charlie Gladhand, the director of marketing, came into the meeting wearing a wide grin. He
explained that he'd read an article about leverage that contained the solution to the company's problem.
The article told of several successful firms that had, to the delight of their owners, become more
successful by borrowing money. Charlie suggests that Armageddon dazzle the Apocalypse Group by
borrowing heavily in the next few days before the conference.
Critique Charlie's idea.
ANSWER: Charlie doesn't understand what he read. Increasing leverage only helps when (1) times are
good, and (2) when there isn't much debt to begin with. Armageddon is doing poorly, so more debt
would make returns worse. But it would also add risk. With the existing debt level at 60%, an addition
would be dangerously risky even in the best of times. In this situation it would probably be a disaster.
2.
You're interested in investing in the Peters Company, which has shown a remarkable increase in
EPS over the last three years. You investigate and find that the company's debt-to-equity ratio has
increased dramatically over the same period and is now four to one. How does this information affect
your feelings about Peters as an investment?
ANSWER: Peters high EPS is based partly on its use of leverage, which seems to have become
excessive. This situation implies high risk in that a modest business downturn is likely to cause a
precipitous drop in EPS and probably stock price. This should dampen investor interest somewhat.
3.
You're the CFO of Axelrod Trucking, a privately held firm whose owner, Joe Axelrod, is
interested in selling the company and retiring. He therefore wants to pump up its value by any means
possible. Joe read an article about leverage in a business magazine the other day, and has sent you a
memo directing that you restructure the firm's capital to the "optimum" in order to maximize the
company's value. Prepare a brief response to Joe's memo.
ANSWER: Joe: Optimizing a company's value by borrowing is a good idea in theory, but it's hard to
put it into practice with any precision. If a firm is doing well, more debt enhances financial results in
terms of ROE and EPS. However, if the company is doing poorly, it makes results worse. That means
increasing the use of debt (known as leverage) makes results more volatile or risky.
Better results tend to enhance value, but riskiness tends to detract from it. The problem is that no one
knows exactly how to balance these two effects to maximize value. In general we can say that if
business performance looks good for the foreseeable future, and the firm doesn't have much debt, a little
more will probably help. On the other hand, a heavily leveraged firm will probably do well to reduce its
debt, especially if business looks shaky ahead.
In our case we can't optimize any better than to estimate that a debt level of about 30% or 35% is
appropriate if times are good. That should be reduced to less than 20% if the outlook is poor.
4.
The Revere Company currently has good earnings and a capital structure that's 20% debt. Its
EPS is in the upper quarter of firms in its industry. Top management's compensation is in large part
based on the year-end price of the company's stock. It's now October and the president, Harry Upscale,
is looking for ways to pump that price before December 31. Harry invests in stocks himself, and pays a

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great deal of attention to EPS when buying and selling. He also understands that leverage can magnify
EPS. However, he knows little more than that about finance. Harry has strongly suggested to the
treasurer that Revere restructure its capital to 65% debt in order to enhance EPS and increase stock
price.
You're an analyst in the firm's treasury department. The treasurer has asked you to prepare an
analysis of Harry's proposal to help him talk the boss out of the idea. You've calculated the company's
current DFL at 2.2, and projected that it would be 5.8 at the proposed leverage level. Draft a memo
from the treasurer to Harry tactfully explaining why his idea may not work and might actually have a
result opposite to what he wants to achieve.
ANSWER: Harry: Our operating results are currently very good, so an increase in leverage will
favorably impact EPS which will tend to have a favorable impact on stock price.
However, that's only part of the picture. Because leverage magnifies EPS, it makes the measure
more volatile when operating results change. In stock market terms, that makes the company more
risky, which tends to negatively influence stock price. Unfortunately, the market's response to increased
risk is a little vague. If there isn't much leverage in the first place, a little extra is more or less ignored.
However, if the absolute level of leverage is high, adding more can have a dramatically negative effect.
This is true even when operating results are good.
The perennial question with respect to leverage is which effect will dominate. In other words, on
balance will price go up or down if a certain amount more leverage is added? That question can rarely
be answered with certainty, but a certain financial ratio may be able to give us some insights into what's
likely to happen.
The Degree of Financial Leverage (DFL) measures the risk associated with leverage. It relates
percentage changes in EPS to percentage changes in EBIT as a function of debt. In other words it tells
how big a change in EPS will occur as a result of any change in EBIT given our debt level. In this way
it measures the financial risk associated with leverage.
Currently our DFL is 2.2. That means a 1% change in EBIT will bring about a 2.2% change in EPS.
If we increase our debt level to 65%, the DFL will be 5.8. That means the change will increase financial
risk by 2.6 times. That's very significant, and it's likely that the market will not respond favorably.
In summary, we advise reconsidering the proposed restructuring since the increase in risk may cause
it to have an effect opposite to that which is hoped for.
5.
The Appleridge Company is a large manufacturer of capital goods. (The demand for capital
goods typically swings up and down a great deal between good and bad economic times.) Business has
been good lately and is expected to remain so in the foreseeable future. The firm is currently relatively
labor intensive in its processes. The chief engineer, Mike Quickwrench, has suggested a major project
to modernize and automate the plant. At the output level planned for next year, the project will reduce
total cost by 10%. Mike has presented the idea to the management team in a totally positive light. The
other executives are caught up in Mike's enthusiasm and are ready to proceed. You're Appleridge's
CFO, and feel that all sides of an issue should be discussed before it is approved. What concerns do you
have? How would you present them in a way that keeps you from appearing to be overly negative?
ANSWER: The problem is the additional risk that the project adds to the company's performance. In
the capital goods industries it's virtually assured that significant downturns will be experienced in the
future as the economy goes through booms and recessions. In some businesses, the downturns are
manageable, say 20% to 30% reductions in volume. In others they're worse, and business almost
disappears for awhile. Therefore, it's particularly important that management evaluate the project at
production levels lower than the one planned for next year. Those levels should be consistent with
previous experience in bad times. It's possible that the automation could put the firm in a position such
that it would fail in a recession.
The CFO should avoid appearing negative about the project, and should present his or her concerns
in terms of exploring all possibilities. Show the results of both good and bad scenarios with some

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subjective probabilities attached. Let the team evaluate which way to go. It's possible that a modified
plan can achieve most of the benefits of the automation, but avoid some of the risk.
6.
The Wycombe Company is doing well and is interested in diversifying, so it's been looking
around for an acquisition target. The Albe Company has been found with the help of an investment
banker. Albe is quite profitable, and about half the size of Wycombe. This size relationship is reflected
in their market values. Both firms are financed entirely by equity. The investment banker has advised
that it will be necessary to pay a premium of about 30% over market price to acquire Albe. Wycombe's
president is having a hard time with this news and has asked you for advice. Construct and explain an
approach to the acquisition that might make the premium easier to rationalize. Would it affect your
argument if neither Albe nor Wycombe were particularly profitable? If so, how?
ANSWER: The president is struggling with the following problem: If Albe's market value truly
represents the firm's worth, the premium represents a payment of extra value from Wycombe's
shareholders to Albe's at the time of the acquisition. Unless there are remarkable benefits to operating
the two firms together, that money is lost to Wycombe's shareholders forever.
Leverage may provide some relief. First notice that neither firm has any debt at present and that they
are both enjoying good profitability. That means an increase in leverage might increase value.
Assume the size relationships of the market values of the two firms are roughly as follows ($100 is
an arbitrary figure for Wycombe, it's the relationships that are important):
Wycombe Market Value
$100
Value of Albe
Market Value
$50
Premium (30%)
15
65
$165
If Wycombe acquires Albe by borrowing $50, the market value of the capital structure of the
resulting firm may be approximately as follows.
Debt
Equity
Total

$ 50 30%
115 70%
$165 100%

This is a reasonable level of leverage that may cause an increase in the value of the equity. To the
extent that such an increase occurs, it will mitigate the loss to Wycombe's stockholders from the
premium payment.
If the firms weren't profitable, increasing leverage would be likely to make their financial results
worse rather than better. That means an increase in stock price and value is unlikely to come from the
idea.
PROBLEMS

Basic Concepts and Calculations: Tables 14-1, 14-2, and Equation 14.1 (pages 600, 601,
and 602)
1.

The Connecticut Computer Company has the following selected financial results.
10% Debt
Debt
Equity
Total Capital

$ 10,000
90,000
$100,000

40% Debt

75% Debt

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Chapter 14

Shares @ $5

18,000

EBIT
Interest ( 15%)
EBT
Tax (40%)
EAT

$18,000
1,500
$16,500
6,600
$ 9,900

ROE
EPS
The company is considering a capital restructuring to increase leverage from its present level of 10% of
capital.
a. Calculate Connecticuts ROE and EPS under its current capital structure.
b. Restate the financial statement line items shown, the number of shares outstanding, ROE, and
EPS if Connecticut borrows money and uses it to retire stock until its capital structure is 40%
debt assuming EBIT remains unchanged and the stock continues to sell at its book value.
(Develop the second column of the chart shown.)
c. Recalculate same figures assuming Connecticut continues to restructure until its capital
structure is 75% debt. (Develop the third column of the chart.)
d. How is increasing leverage affecting financial performance? What overall effect might the
changes have on the market price of Connecticuts stock? Why? (Words only. Hint: consider
the move from 10% to 40% and that from 40% to 75% separately.)
SOLUTION: a., b., c.
10% Debt

40% Debt

75% Debt

Debt
Equity
Total Capital

$ 10,000
90,000
$100,000

$ 40,000
60,000
$100,000

$ 75,000
25,000
$100,000

Shares @ $5

18,000

12,000

5,000

EBIT
Interest ( 15%)
EBT
Tax (40%)
EAT

$18,000
1,500
$16,500
6,600
$ 9,900

$18,000
6,000
$12,000
4,800
$ 7,200

$18,000
11,250
$ 6,750
2,700
$ 4,050

ROE
EPS

11.0%
$.55

12.0%
$.60

16.2%
$.81

d. Increasing leverage is improving financial performance as measured by ROE and EPS. As debt
increases, earnings, equity, and the number of shares outstanding all decrease. However, since equity
decreases fastest the ratios ROE (EAT/Equity) and EPS (EAT/Shares) get larger.
The increase in debt from 10% to 40% of capital is likely to increase stock price, because
investors will react favorably to the improvement in ratios. In this leverage range debt is not
excessively high, so the positive effect of the improving ratios will probably overcome the negative
effect of increasing risk.

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Capital Structure and Leverage

The move from 40% to 75% debt, on the other hand, is likely to be perceived by investors as
making the company uncomfortably risky. At higher leverage levels the negative effect on investors of
increased risk usually overwhelms the positive effect of improving performance ratios, and the net result
is a decline in stock price.
2.
Reconsider the Connecticut Computer Company of the previous problem assuming the firm has
experienced some difficulties, and its EBIT has fallen to $8,000.
a. Reconstruct the three-column chart developed in problem 1 assuming Connecticuts EBIT
remains at $8,000.
b. Interpret the result in terms of stock price and the advisability of restructuring capital under
these conditions.
c. Could these results have been predicted more easily? Use the ROCE concept to come to the
same conclusion.
SOLUTION: a.
10% Debt

40% Debt

75% Debt

Debt
Equity
Total Capital

$ 10,000
90,000
$100,000

$ 40,000
60,000
$100,000

$ 75,000
25,000
$100,000

Shares @ $5

18,000

12,000

5,000

EBIT
Interest ( 15%)
EBT
Tax (40%)
EAT

$8,000
1,500
$6,500
2,600
$ 3,900

$8,000
6,000
$2,000
800
$1,200

$ 8,000
11,250
($ 3,250)
($ 3,250)

ROE
EPS

4.3%
$.22

2.0%
$.10

(13.0%)
($.65)

b. Stock price would almost certainly decline as a result of restructuring. Increased debt is causing a
deterioration of financial performance measured by ROE and EPS as well as increasing risk. Both of
these have negative effects on investors attitudes. Under these conditions (a low EBIT) it would
virtually never be advisable to exchange equity for debt.
c. Leverage is not advisable if the return on capital employed, ROCE, is less than the after tax cost of
debt. Currently Connecticuts ROCE is
ROCE = EBIT(1 T) / (Debt + Equity)
= $8,000(1 .4) / $100,000
= $4,800 / $100,000
= 4.8%
Its after tax cost of debt is
15%(1 T) = 15%(1 .4) = 9%
Hence at an EBIT of $8,000, Connecticuts ROCE is less than its after tax cost of debt and we would not
expect adding leverage to do the firm any good.

342

Chapter 14

3.
Assume Connecticut Computer Company of the last two problems is earning an EBIT of
$15,000. Once again, calculate the chart showing the implication of adding more leverage. Verbally
rationalize the result.
SOLUTION:
10% Debt

40% Debt

75% Debt

Debt
Equity
Total Capital

$ 10,000
90,000
$100,000

$ 40,000
60,000
$100,000

$ 75,000
25,000
$100,000

Shares @ $5

18,000

12,000

5,000

EBIT
Interest ( 15%)
EBT
Tax (40%)
EAT

$15,000
1,500
$13,500
5,400
$ 8,100

$15,000
6,000
$9,000
3,600
$ 5,400

$15,000
11,250
$ 3,750
1,500
$ 2,250

9.0%
$.45

9.0%
$.45

9.0%
$.45

ROE
EPS

Leverage has no effect on financial performance, but it still adds risk hence the effect on stock
price would probably be negative.
At an EBIT of $15,000 the ROCE and the after tax cost of debt are both 9%. Trading equity for
debt or vice versa makes no difference on performance, because the firm is earning on capital exactly
what it pays for the use of additional debt funds. I.e., theres no leverage. The risk effect, however, is
still there because as the firm adds more debt it must pay more interest making its profit margin
narrower. This will probably drive the stocks price down in the absence of a counteracting favorable
change in ratios.
4.
Watson Waterbed Works Inc. has an EBIT of $2.75 million, can borrow at 15% interest, and
pays combined state and federal income taxes of 40%. It currently has no debt and is capitalized by
equity of $12 million. The firm has 1.5 million shares of common stock outstanding that trade at book
value.
a. Calculate Watson's EAT, ROE, and EPS currently and at capital structures that have 20%, 40%,
60%, and 80% debt.
b. Compare the EPS at the different leverage levels, and the amount of change between levels as
leverage increases. What happens to the effect of more debt as leverage increases from a little to a
lot?
SOLUTION:
a.
INCOME STATEMENT
EBIT
Interest
EBT
Tax
EAT

All
Equity
$ 2,750
-__
$ 2,750
1,100
$ 1,650

20%
Debt
$ 2,750
360
$ 2,390
956
$ 1,434

40%
Debt
$ 2,750
720
$ 2,030
812
$ 1,218

60%
Debt
$ 2,750
1,080
$ 1,670
668
$ 1,002

80%
Debt
$ 2,750
1,440
$ 1,310
524
$ 786

343

Capital Structure and Leverage

BALANCE SHEET
Debt
Equity
Capital

$12,000
$12,000

$ 2,400
9,600
$12,000

$ 4,800
7,200
$12,000

$7,200
4,800
$12,000

$ 9,600
2,400
$12,000

1.5M

1.2M

.9M

.6M

.3M

13.8%
$1.10

14.9%
$1.20

16.9%
$1.35

20.9%
$1.67

32.8%
$2.62

Shrs @ $8
ROE
EPS

b.
The effect of leverage accelerates as more leverage is added. That is, the same increment of
debt brings larger changes in ROE and EPS as leverage increases.

Managing EPS Through Leverage: Example 14-1 (page 602)

5.
The Tanenbaum Tea Company wants to show the stock market an EPS of $3 per share, but
doesn't expect to be able to improve profitability over what is reflected in the financial plan for next
year. The plan is partially reproduced as follows.
Tanenbaum Tea Company
Financial Projection 200X
($000)
EBIT
Interest (@12%)
EBT
Tax (38%)
EAT

$18,750
1,560
$17,190
6,532
$10,658

Debt
$ 13,000
Equity
97,000
Capital $110,000
#shares = 3,700,000

Tanenbaum's stock sells at book value. Will trading equity for debt help the firm achieve its EPS
goal, and if so what debt level will produce the desired EPS?
SOLUTION:
In ($000)

ROCE

EBIT(1 T)

$18,750(.6 2)

10.6%
Debt Equity
$110,000
After-tax cost of debt = kd(1T) = 12%(.62) = 7.4%
Hence,
ROCE > kd(1T) => more leverage will help performance.
Book value per share = $97M/3.7M shares = $26.2162.
Trial and error leads to the correct debt level of $24M, from which:
EBIT
$18,750
Debt
$ 24,000
Interest (@12%)
2,880
Equity
86,000
EBT
$15,870
Capital $110,000
Tax (38%)
6,031
EAT
$ 9,839
Change in equity = $97M $86M
Shares retired at book value = $11,000,000 / $26.2162 = $419,588

344

Chapter 14

New number of shares outstanding = 3,700,000 419,588 = 3,280,412

New EPS = EAT / # shares = $9,839,000 / 3,280,412 = $3.00

Basics Plus DFL: Apply Equation 14.3 (page 611)

6.
The Canterbury Coach Corporation has EBIT of $3.62 million, and total capital of $20 million,
which is 15% debt. There are 425,000 shares of stock outstanding which sell at book value. The firm
pays 12% interest on its debt and is subject to a combined state and federal tax rate of 40%. Canterbury
is contemplating a capital restructuring to either 30%, 45%, 60%, or 75% debt.
a. At the current level of profitability, will more debt enhance results? Why?
b. Calculate the EAT, ROE, EPS, and the DFL at the current and proposed structures, and display
your results in a systematic table.
c. In a short paragraph referring to your table, discuss the trade-off between performance and
increased risk (reflected in the DFL) as leverage increases. Do some levels seem to make more sense
than others? What business characteristics would make the higher leverage levels less of a problem?
SOLUTION:
a. In ($000)

EBIT(1 T)
$3,620(.6)

10.86%
Debt Equity
$20,000
After-tax cost of debt = kd(1T) = 12%(.6) = 7.2%
Hence,
ROCE > kd(1T)
which implies that more leverage will improve performance.
ROCE

b.
INCOME STATEMENT
Current

Proposals

15%
Debt
$ 3,620
360
$ 3,260
1,304
$ 1,956

30%
Debt
$ 3,620
720
$ 2,900
1,160
$ 1,740

45%
Debt
$ 3,620
1,080
$ 2,540
1,016
$ 1,524

60%
Debt
$ 3,620
1,440
$ 2,180
872
$ 1,308

75%
Debt
$ 3,620
1,800
$ 1,820
728
$ 1,092

$ 3,000
$17,000
$20,000

$ 6,000
14,000
$20,000

$ 9,000
11,000
$20,000

$12,000
8,000
$20,000

$15,000
5,000
$20,000

Shares
Book Value

425,000
$40

350,000
$40

275,000
$40

200,000
$40

125,000
$40

ROE
EPS

11.5%
$4.60

12.4%
$4.97

13.9%
$5.54

16.4%
$6.54

21.8%
$8.74

1.25

1.43

1.66

1.99

EBIT
Interest
EBT
Tax
EAT
BALANCE SHEET
Debt
Equity
Capital

DFL = EBIT /(EBITI)

DFL
1.11

345

Capital Structure and Leverage

c.
As performance accelerates, so does the risk implied by the increasing DFL. The highest level
of leverage yields financial risk that almost doubles business risk. That intuitively seems unacceptable.
The 45% level seems reasonable. If EBIT is stable, however, there is less reason to be concerned about
more leverage.

Forecasting Results Through the DFL: Example 14-2 (page 611)

7.

Balfour Corp has the following operating results and capital structure ($000).
Revenue
Cost/Expense
EBIT

$6,000
4,500
$1,500

Debt
Equity
Total

$ 1,200
8,800
$10,000

The firm is contemplating a capital restructuring to 60% debt. Its stock is currently selling for book
value at $25 per share. The interest rate is 9%, and combined state and federal taxes are 42%.
a. Calculate EPS under the current and proposed capital structures.
b. Calculate the DFL under both structures.
c. Use the DFLs to forecast the resulting EPS under each structure if operating profit falls off by 5%,
10%, or 25%.
d. Comment on the desirability of the proposed structure versus the current one as a function of the
volatility of the business.
e. Is stock price likely to be increased by a change to the proposed capital structure? Discuss briefly.
SOLUTION: ($000)
INCOME STATEMENT
Current
EBIT
$1,500
Interest (9%)
108
EBT
$1,392
Tax (42%)
585
EAT
$ 807

Proposed
$1,500
540
$ 960
403
$ 557

BALANCE SHEET
Debt
Equity
Capital

$ 1,200
8,800
$10,000

$ 6,000
4,000
$10,000

#Shares = Eq/BV per share

$8,800,000/$25 = 352,000
$4,000,000/$25 =

160,000

a. EPS = EAT / # Shrs

Current: $807/352 = $2.29
Proposed: $557/160 =

$3.48

b. DFL = EBIT / EBT

Current: $1,500/$1,392 = 1.08
Proposed: $1,500/$960 =

1.56

c. % EPS = DFL (% EBIT)

Fcst EPS = EPS (1 % EBIT)

346

Chapter 14

% EBIT
5%
10%
25%

Current
% EPS
5.4%
10.8%
27.0%

Fcst EPS
$2.17
$2.04
$1.67

Proposed
% EPS
Fcst EPS
7.8%
$3.21
15.6%
$2.94
39.0%
$2.12

d.
EPS is higher but more variable under the proposed structure. However, at a 25% reduction in
EBIT, EPS is still better under the proposal than under the old structure. Hence if operating profitability
isn't expected to vary much, the proposal may be a good idea.
e.
We can't say for sure because the ultimate impact on stock price depends on investors'
subjective feelings about risk and return trade-off. However, it looks likely that the impact would be
favorable if EBIT isn't expected to vary more than 25%.
8.
Algebraically derive EPS = ROE [Book value per share].
(Hint: Write the definitions of ROE, EPS, and book value, and then start substituting.)
SOLUTION:
Write the definition of EPS and solve for EAT
EPS = EAT / # Shrs
EAT = EPS (# Shrs)
Write the definition of ROE and substitute for EAT
ROE = EAT/Equity = EPS (# Shrs)/Equity
Solve for EPS
EPS = ROE [Equity/# Shrs].
But since [Equity/# Shrs] is Book value per share,
EPS = ROE (Book Value per Share).

EBIT-EPS Analysis: Example 14.3 (page 613)

9.
You're a financial analyst at Pinkerton Interactive Graphic Systems (PIGS), a successful entrant
in a new and rapidly growing field. As in most new fields, however, rapid growth is anything but
assured, and PIGS's future performance is uncertain.
The firm expects to earn operating profits of $4 million next year, up from $1 million last year. To
support this enormous growth the firm plans to raise $15 million in new capital. It already has capital of
$5 million, which is 40% debt.
PIGS can raise the new money in any proportion of debt and equity management chooses. The CFO
is considering three possibilities: all equity, $8 million debt and $7 million equity, and all debt.
Interest on the current debt as well as on new borrowing is expected to be 10%, and the company
pays state and federal income taxes at a combined rate of 40%. Equity will be raised by selling stock at
the current market price of $10 which is equal to its book value.
The CFO has asked you to prepare an analysis to aid management in making the debt/equity
decision. You are also to provide a recommendation of your own.
a. Prepare an EBIT-EPS analysis of the situation showing a line for the capital structure that results
from each of the three options. Calculate EPS under each new capital structure at EBIT levels of $1
million, $2 million, and $4 million. Then graph EBIT versus EPS for each option. Refer to Figure 143. Show last year's EPS on the graph.
b. Discuss the effect the options might have on stock price.
c. Make a subjective recommendation under each of the following assumptions about the $4 million
forecast. Support your position with words and references to your EBIT-EPS analysis.

347

Capital Structure and Leverage

1. The $4 million Operating Profit projection is a best-case scenario. Anything from ($2 million) to $4
million has an equal probability of occurring.
2. The $4 million is a fair estimate with about a 60% probability. However, performance better than $4
million is unlikely. EBIT results could range anywhere from zero to $4 million.
3. $4 million is an easy target. There's an even chance of anything between $4 million and $8 million.
SOLUTION: a.
CAPITAL
Current
Structure
Debt $2,000
Equity 3,000
Total $5,000
# Shrs 300

Options for New

Capital Additions
1
2
3
$8,000 $15,000
$15,000 $7,000
1,500

700

Possible New Structures

1
2
3
$ 2,000
$10,000
$17,000
18,000
10,000
3,000
$20,000
$20,000
$20,000
1,800
1,000
300

Note that the number of shares comes from dividing equity by $10 per share, which is market price
as well as book value.
INCOME STATEMENTS AT EBIT = $4,000
1
EBIT
Interest
EBT
Tax
EAT
EPS

$4,000
200
$3,800
1,520
$2,280
$ 1.27

Capital Structure Options

2
$4,000
1,000
$3,000
1,200
$1,800
$ 1.80

3
$4,000
1,700
$2,300
920
$1,380
$ 4.60

INCOME STATEMENTS AT EBIT = $2,000

Capital Structure Options
1
2
EBIT
Interest
EBT
Tax
EAT
EPS

$2,000
200
$1,800
720
$1,080
$0.60

$2,000
1,000
$1,000
400
$ 600
$0.60

3
$2,000
1,700
$ 300
120
$ 180
$0.60

INCOME STATEMENTS AT EBIT = $1,000

348

Chapter 14

Capital Structure Options

1
2
EBIT
Interest
EBT
Tax
EAT
EPS

$1,000
200
$ 800
320
$ 480
$ 0.27

$1,000
1,000
$
0
0
$
0
$ 0.00

3
$1,000
1,700
($ 700)
( 280)*
($ 420)
($ 1.40)

For illustrative purposes assume a tax credit on losses.

Note that last year's income Statement is identical to Column 1 in the last table except that there are
300,000 shares of stock outstanding, which yields an EPS of $1.60.
EPS
$5.00

-3-

$4.00
$3.00
-2$2.00
-1$1.00

EBIT
$1,000

$2,000

$3,000

$4,000

b. The three options display a wide range of choices with respect to the trade-off between risk and
performance. Option one is relatively conservative in that there's almost no loss at EPS until a loss is
experienced at EBIT. Option three, on the other hand, is very risky getting into negative EPSs while
operating profits are still good. Intuitively, option three seems risky enough to decrease stock price.
The choice between options one and two is subjective. An important point, however, is a comparison
with last year's EPS, which can be calculated at $1.60. Option one will result in a decline in EPS at the
expected level of EBIT. That fact is likely to make it unacceptable.
c. 1) This is a high risk scenario in which most people would probably choose option one. Even that
gives only about a 2/3 probability of a positive EPS. The others are worse. Option three looks like it
could bankrupt the firm toward the bottom of the EBIT range.
2)This is a common business situation: A likely outcome has more downside risk than upside
potential. Either of the first two options is supportable.
3) Option three is clearly the best choice if the outlook is really this good.

Contribution and Breakeven: Examples 14-4 and 14-5 (pages 619 and 620)

349

Capital Structure and Leverage

10.
Cranberry Wood Products Inc. spends an average of $9.50 in labor and $12.40 in materials on
every unit it sells. Sales commissions and shipping amount to another $3.10. All other costs are fixed
and add up to $140,000 per month. The average unit sells for $32.00.
a. What are Cranberry's contribution and contribution margin?
b. What is the firm's breakeven point in units?
c. Calculate the dollar breakeven point in two ways.
d. Sketch the Breakeven Diagram.
SOLUTION:
Variable cost per unit = V = Labor + Material + C&S
V = $9.50 + $12.40 + $3.10 = $25.00
a.
b.
c.

Ct = P V =$32 $25 = $7.00

CM = (P V)/P = $7/$32 = .21879 = 21.9%
QB/E = FC/Ct = $140,000/$7 = 20,000
SB/E = P(FC)/Ct = ($32)$140,000/$7 = $640,000
SB/E = FC/CM = $140,000/.21875
= $640,000

d.
Rev
$640,000

TC

FC

$140,000

Q
20,000 Units

Fixed/Variable Cost Tradeoff and DOL: Examples 14.6 and 14.7 (pages 622 and 624)
11.

Referring to the Cranberry Company of the previous problem:

a. Calculate the DOL when sales are 20%, 30% and 40% above breakeven.
b. Suppose automated equipment is added which increases fixed costs by $20,000 per month. How
much will total variable cost have to decrease to keep the breakeven point the same?
c. Calculate the DOL at the same output levels used in part a.
d. Comment on the differences in DOL with and without the additional equipment.
SOLUTION:

DOL
a.
B/E+
20%
30%
40%

Q( P V )
7Q

Q(P V) FC 7Q $140 ,000

Q
24,000
26,000
28,000

DOL
6.0
4.3
3.5

350

Chapter 14

b.

QB/E = FC/(PV)
After automated Equipment installed,
FC = $160,000, QB/E = 20,000, and P = $32
So,
20,000 = $160,000 / ($32V),
from which
V = $24.
Previously,
V = $25,
so the required decrease is $1 per unit.
c.

DOL
B/E+
20%
30%
40%
d.

Q( P V )
8Q

Q(P V ) FC 8Q $160,000
Q
DOL
24,000
6.0
26,000
4.3
28,000
3.5

The DOL around a fixed breakeven point is a function of quantity only as the mix of fixed and
variable costs shifts.

Problems 12 15 refer to Burl Wood Products (BWP), a manufacturer of high quality

furniture.
12.

BWP projects sales of 100,000 units next year at an average price of $50 per unit. Variable
costs are estimated at 40% of revenue, and fixed costs will be $2.4 million. BWP has $1 million
in bonds outstanding on which it pays 8%, and its marginal tax rate is 40%. There are 100,000
shares of stock outstanding which trade at their book value of $30. Compute BWPs
contribution, contribution margin, EAT, DOL and EPS.

SOLUTION:($ Millions)
Revenue 100,000 x $50
Variable Cost @ 40%
Contribution Margin
Fixed Costs
EBIT
Interest Expense
$1.0 x .08
EBT
Tax @ 40%
EAT
Contribution
50 (50 x .4)
Contribution Margin
30/50
EAT
DOL {100,00(50-20)/[100,000(50-20)-2400000]}
EPS
$312,000/100,000

$5.00
2.00
3.00
2.40
.60
.080
.520
.208
.312
$30
60%
$312,000
5
$3.12

351
13.

Capital Structure and Leverage

BWP intends to purchase a machine that will result in a major improvement in product quality
along with a small increase in manufacturing efficiency. The machine will cost $1 million,
which will be borrowed at 9%. The quality improvement is expected to have a significant
impact on BWPs competitive position. Indeed, management expects sales to increase by 5% in
spite of a planned 10% price increase. The efficiency improvement combined with the price
increase will result in variable costs of 36% of revenue. Fixed cost, however, will rise by 19%.
a. Compute BWPs, new contribution, contribution margin, EAT, DOL and EPS if it
purchases the new machine.
b. If all of BWPs projections come to pass, how will stock price be influenced? What
factors should be considered in estimating a stock price change?

SOLUTION: ($ Millions)
a.
Revenue (100,000 x $50 x 1.1 x 1.05)
Variable Cost @ 36%
Contribution Margin
Fixed Costs
($2.4 x 1.19)
EBIT
Interest Expense
($1.0 x .08 + $1.0 x .09)
EBT
Tax @ 40%
EAT
Contribution
($55 - .36x $55)
Contribution Margin
($35.20/$55)
EAT
DOL {105,00(35.20)/[105,000(35.20)-2856000]}
EPS
($402,000/100,000)

$5.775
2.079
3.696
2.856
.840
.170
.670
.268
.402
$35.20
64%
402,000
4.4
$4.02

b.

An increase in EPS will have a positive effect on stock price. A doubling of debt, however,
might have a negative effect, especially if debt was already a significant percentage of capital.
The decrease in DOL means results will be less volatile which should have a positive effect. It
isnt possible to say with certainty which effect will dominate.

14.

Calculate BWPs DFL and DTL before and after the acquisition of the new machine.

SOLUTION:
DFL = EBIT/(EBIT I) =
DTL = DOL x DFL =
15.

W/O machine
.6/.52 = 1.15
5.0 x 1.15 = 5.75

W/machine
.84/.67 = 1.25
4.4 x 1.25 = 5.5

Use the information from the previous two problems. Calculate BWPs breakeven point in units
and dollars, with and without the purchase of the new machine.

SOLUTION:
Without machine:
With machine:

$2.4 million/$30 = 80,000 units

80,000 units x $50 = $4000,000
$2.856 million/$35.20 = 81,137 units
81,137 units x $55 = $4,462,535

352

Chapter 14

Degree of Total Leverage (DTL): Example 14.8 (page 627)

16.
The Spitfire Model Airplane Company has the following modified income statement ($000) at
100,000 units of production.
Revenue
$10,000
Variable Cost
6,500
Fixed Cost
2,200
EBIT
$ 1,300
Interest (@ 10%)
500
EBT
$ 800
Tax (@ 40%)
320
EAT
$ 480
# shares
20,000
a. What are Spitfire's contribution margin and dollar breakeven point?
b. Calculate Spitfire's current DFL, DOL, and DTL.
c. Calculate the current EPS and estimate what it would become if sales declined by 25%. Use the
DTL first and then recalculate the modified income statement. (Assume a negative EBT generates a
negative tax.)
SOLUTION:
a.
P = $10M/100,000 = $100
V = $6.5M/100,000 = $65
CM

= (PV)/P = ($100 $65)/$100 = .35

SB/E = FC/CM = $2,200,000/.35 = $6,285,714

b.

DFL

EBIT
$1,300

1.625
EBIT I $1,300 $500

DOL

Q( P V )
100,000 ($35)

2.692
Q(P V ) FC 100,000 ($35) $2,200,000

DTL = DOL DFL = 2.692 1.625 = 4.375

c. A 25% decline in sales implies EPS will decline by
25% DTL = 25% 4.375 = 109.4%
109.4% of $24 = $26.26
$24 $26.26 = $2.26
Recalculating the income statement:
Revenue
Variable Cost
Fixed Cost
EBIT
Interest (@ 10%)
EBT

$7,000
4,875
2,200
$ 425
500
$ ( 75)

353

Capital Structure and Leverage

Tax (@ 40%)
EAT
# shares

( 30)
$ ( 45)
20,000

EPS = $45,000/20,000 = $2.25

17.
The Singleton Metal Stamping Company is planning to buy a new computer controlled
stamping machine for $10 million. The purchase will be financed entirely with borrowed money that
will change Singleton's capital structure substantially. It will also change operations by adding $1.5
million in fixed cost and eliminating $2 million in variable cost at the current level of sales.
The firm's current financial position is reflected in the following statement ($000).
Revenue
Variable Cost
Fixed Cost
EBIT
Interest (@ 10%)
EBT
Tax (@ 40%)
EAT

$18,000
10,000
5,000
$ 3,000
500
$ 2,500
1,000
$ 1,500

Debt $ 5,000
Equity 15,000
Total $20,000
#shares 750,000
EPS

= $2.00

a. Restate the financial statements with the new machine, and calculate the dollar breakeven points
with and without it.
b. Calculate the DFL with and without the new machine.
c. Calculate the DOL with and without the new machine. (Hint: You don't need Q to use equation
(14-11), because PQ is revenue and VQ is total variable cost.)
d. Calculate the DTL with and without the new machine.
e. Comment on the variability of EPS with sales and the sources of that variability.
f. Is it a good idea to buy the new machine if sales are expected to remain near current levels? Give
two reasons why or why not. What has to be anticipated for the project to make sense?
SOLUTION:
a.
Financial Statements With New Machine
Revenue
$18,000
Variable Cost
8,000
Debt $15,000
Fixed Cost
6,500
Equity 15,000
EBIT
$ 3,500
Total $30,000
Interest (@ 10%)
1,500
#shares 750,000
EBT
$ 2,000
Tax (@ 40%)
800
EPS
$1.60
EAT
$ 1,200
(Notice that performance is worse with the new machine.)
Current

New

Breakeven
CM

$8,000
.4444
$18,000

$10,000
.5556
$18,000

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Chapter 14

$5,000
$11,251
.4444

$6,500
$11,701
.5556

$3,000
1.20
$2,500

$3,500
1.75
$2,000

DOL

$8,000
2.67
$3,000

$10,000
2.86
$3,500

DTL

1.20(2.67) = 3.2

1.75(2.86) = 5.0

B/E
b.
DFL
c.

d.

e. EPS will vary substantially more (5.0/3.2 1 = 56%) under the new plan. Most of the variation will
come from the increase in financial risk reflected in the DFL.
f.

The new machine doesn't seem to be a good idea for two reasons:
1. At current production levels, financial performance gets worse, and
2. Financial performance is considerably more variable (risky) with the machine.
The project would make sense if a big increase in volume was expected.
18.

Schoen Industries pays interest of $3 million each year on bonds with an average coupon rate
of 7.5%. The firm has 4.5 million shares of stock outstanding and pays out 100% of earnings in
dividends. Earnings per share (EPS) is $3.50. Schoens cost of equity is 12%. Calculate the
firms total value (the value of its debt plus that of its equity) under the assumptions of
Modigliani and Millers simplest model. I.e., that there are no taxes and no transactions costs in
financial markets. (Hint: Use Equations 14.15 - 14.17.)

SOLUTION:
VF = Vd + Ve
VF = $3.0M/.075 + $3.50 x 4.5M shares/.12
=$40 M+ $131.25M
= $171.25M
19.

Assume Schoen Industries of the last problem is subject to income tax at a rate of 40%.
a. Recalculate the value of the firm assuming there is no tax shield associated with debt and
compare it to the value calculated in the last problem. That is, assume interest is subtracted in
calculating earnings, but is not deductible in calculating taxes. How much value has theoretically been
lost to investors as a result of taxes? Which investors suffer the loss, stockholders or bondholders?
b. What is the value of the tax shield associated with the firms debt? What is the benefit of
debt? Calculate the theoretical value of the firm including the benefit of debt and compare it with the
value calculated in the last problem? Who gets the incremental value resulting from the tax shield?
c. Under what conditions, assuming bankruptcy costs are introduced, are investors likely to
receive the full benefit of debt calculated in part b? (Words only.)
SOLUTION:
a. Earnings without tax were
$3.50 x 4.5M shares =

$15.75M

355

Capital Structure and Leverage

Add interest payments
Taxable income
Less tax at 40%
Less interest
Earnings available for dividends

3.00M
$18.75M
7.50M
3.00M
$ 8.25M

Vf = Vd + Ve = I / kd + D / ke
= $3M / .075 + $8.25 / .12
= $40M + $68.75M
= $108.75M
Loss in value due to taxes
Previous value
Value with tax but no tax shield
Loss in value to investors

$ 171.25M
(108.75M)
$ 62.50M

Stockholders suffer the entire loss, because interest payments are fixed by Schoens bond contracts.
b. The (annual) tax shield associated with debt is the tax saved by making deductible interest payments,
which is simply the payment times the tax rate. In Schoens case thats
$3M x .4 = $1.2M
The benefit of debt is the present value of the annual tax shield in perpetuity capitalized at the return on
debt.
$1.2M / .075 = $16M
The benefit of debt is an addition to the value calculated earlier in this problem. Hence the value with
deductible taxes is
Value with tax but no tax shield
Benefit of debt

$108.75M
16.00M
$124.75M

The benefit of debt accrues entirely to stockholders for the same reason they suffered the entire value
loss from the imposition of taxes, because interest payments are fixed by Schoens bond contracts.
c. The introduction of bankruptcy costs causes the value of the firm to decline below the theoretical
value with taxes because investors become concerned about risk as debt increases. See Figure 14.13a.
Further, investor concern about risk is heightened if the company is facing difficult business conditions.
Hence the full benefit of debt is likely to be achieved only at low debt levels and when business is
reasonably good.