151

Leverage and the Debt-Equity Mix

QUESTIONS
1. In what way is business leverage similar to physical leverage Both types of leverage
involve magnification. In both, we carefully construct our system to produce the magnified
result. The differences are in what is magnifiedincome vs. physical force, and what serves
as the leverfixed costs vs. a mechanical device.
!. "istinguish between operating leverage an# $inancial leverage. Both operating and
financial leverage result in the magnification of changes to earnings due to the presence of
fixed costs in a company's cost structure. The difference is only the part of the income
statement we are looking at. Operating leverage is the magnification on the top half of the
income statementhow BIT changes in response to changes in sales! the relevant fixed cost
is the fixed cost of operating the business. "inancial leverage is the magnification on the
bottom half of the income statementhow earnings per share changes in response to changes
in BIT! the relevant fixed cost is the fixed cost of financing, in particular interest.
%. &ow much choice #oes a $irm have over its operating leverage Over its $inancial
leverage #hoice over operating leverage depends on the technologies available to a
company. $ome companies have little control over their operating leverage. "or example,
airlineswhich have no substitute for airplanes and their associated support systemscan
only operate with a large investment in fixed assets that create fixed costs. Other companies
have a significant degree of control over their operating leverage. %any manufacturing
companies, for example, can choose to produce using automated e&uipment or piecework
labor. By contrast, most firms have total control over their financial leverage through their
choice of financing 'the exception is small firms that have limited access to financial markets,
hence limited financing alternatives(. ) company can increase its financial leverage by using
debt financing and can avoid financial leverage through financing with e&uity.
'. "escribe the way in which earnings per share respon#s to changing E(IT in a $irm
with)
a. No $i*e# $inancing costs. ) firm with no fixed financing costs has no financial leverage.
In such a firm, earnings per share will rise and fall with BIT by the same percentage. "or
example, a *+, increase in BIT will result in a *+, increase in -$! a ., decrease in
BIT will result in a ., decrease in -$.
15! +hapter 15
b. Some $i*e# $inancing costs. ) firm with some fixed financing costs does have financial
leverage. In such a firm, earnings per share will rise and fall with BIT by a greater
percentage. "or example, a *+, increase in BIT will result in a more/than/*+, increase
in -$! a ., decrease in BIT will result in a more/than/., decrease in -$.
5. &ow #oes a $irm,s $inancial leverage a$$ect) "inancial leverage changes a firm's returns and
risk.
a. Its pro$itability "inancial leverage changes a firm's earnings per share. To the left of the
indifference point 'lower BIT( between financing alternatives 'refer to "igure *+.0, p.
+11( financial leverage reduces -$. To the right of the indifference point 'greater BIT(
-$ is increased as the firm takes on financial leverage. This observation indicates the
importance of knowing the indifference point and where a company's level of BIT is
relative to it.
b. Its level o$ ris- "inancial leverage increases the volatility of a firm's earnings per share.
)s a firm increases its financial leverage, its -$ will rise and fall by magnified amounts in
response to changes in BIT. This makes the -$ stream riskier for investors. )lso, the
possibility that -$ could be lower than if there were less financial leverage 'if BIT is
left of the indifference point( and the power over the firm given to creditors should the
firm have difficulty paying its debts create additional risks for shareholders.
.. / $irm is consi#ering two alternative capital structures0 an# has calculate# its
pro$itability at various E(IT levels un#er each structure. 1hat shoul# the $irm #o i$ its
pro2ecte# E(IT is)
a. (elow the in#i$$erence point In this case, choose the capital structure with the lower
degree of financial leverage. If BIT is below 'to the left of( the financing indifference
point, higher financial leverage would decrease -$ 'lower return( as it increases the
volatility of the -$ stream 'higher risk(. 2owever, lower financial leverage would
increase -$ 'higher return( and decrease the volatility of the -$ stream 'lower risk(, the
combination preferred by risk/averse investors.
b. /bove the in#i$$erence point In this case, the choice of capital structure is not obvious,
since there is a tradeoff between the effects of financial leverage on risk and return. If
BIT is above 'to the right of( the indifference point, higher financial leverage would
increase -$ 'higher return( but also increase the volatility of the -$ stream 'higher
risk(. 3ower financial leverage would decrease -$ 'lower return( and decrease the
volatility of the -$ stream 'lower risk(. "urther analysis is re&uired to identify which
capital structure provides investors with the best risk/return combination.
3. +ompare an# contrast the 4net income approach05 4net operating income approach05
an# 4tra#itional approach5 to the optimal #ebt6e7uity mi*. 1hich assumptions #o you
$in# reasonable Unreasonable The net income approach, net operating income
approach, and traditional approach are three theoretical frameworks for how a company
should set its debt/e&uity mix. )ll three examine how a company's cost of capital changes
with the debt/e&uity mix and search for the lowest value of the cost of capital, hence the
maximum value of the firm, to identify the best mix. They reach different conclusions because
they make different assumptions about creditors' and investors' reactions to increasing debt.
8everage an# the "ebt6E7uity 9i* 15%
ach of us will have our own feelings about the reasonableness of the assumptions. 4ithout
going into the %odigliani/%iller mathematics, the assumptions of the traditional approach
usually seem most reasonable to most people.
'*( The net income approach makes the simplest assumptions, that neither creditors nor
investors increase their re&uired rates of return as a company takes on debt. The cost of
capital declines as higher/cost e&uity is replaced with lower/cost debt. This approach
concludes that the optimal financing mix is all debt.
'5( The net operating income approach assumes that creditors do not increase their re&uired
rate of return as a company takes on debt, but investors do. "urther, the rate at which
investors increase their re&uired rate of return as the financing mix is shifted toward debt
exactly offsets the weighting away from the more expensive e&uity and toward the
cheaper debt. The result is that the cost of capital remains constant regardless of the
financing mix. This approach concludes that there is no optimal financing mixany mix is
as good as any other.
'1( The traditional approach assumes that both creditors and investors increase their re&uired
rates of return as a company takes on debt. )t first this increase is small, and the
weighting toward lower/cost debt pushes the cost of capital down. ventually, the rate at
which creditors and investors increase their re&uired rates of return accelerates and
dominates the weighting toward debt, pushing the cost of capital back upward. The result
is that the cost of capital declines with debt and reaches a minimum point before rising
again. This approach concludes that there is a optimal financing mix consisting of some
debt and some e&uity.
:. 1hat role #oes each o$ 99,s assumptions play in their theory o$ the #ebt6e7uity
mi* %%'s key assumptions and the role played by each are6
'*( 7nlimited borrowing and lending is available to all market participants at one rate of
interest. 8ole6 makes the cost of personal and corporate borrowing and lending the same.
'5( Individual margin borrowing is secured by the shares purchased, the borrower's liability is
limited to the value of these shares, there are no costs to bankruptcy. 8ole6 makes the risk
of personal and corporate borrowing and lending the same.
'1( )ll companies can be grouped into e&uivalent risk classes. 8ole6 enables investors to
identify companies with identical business risk.
'0( #apital markets are perfect. 8ole6 permits investors to easily and costlessly arbitrage
between securities of companies which differ only in their financing mix.
'+( There are no corporate income taxes. 8ole6 prevents the tax code from making debt
financing more valuable by allowing interest and not dividends as a tax deduction.
'9( $hareholders are indifferent to the form of their returns, all returns are taxed at the same
rate. 8ole6 prevents investors from seeing any difference in value between interest,
dividends, and capital gains.
;. "escribe 4homema#e leverage.5 2omemade leverage is investors' method of substituting
their own borrowing or lending for corporate borrowing. Investors who want more leverage
than a company has taken on can buy the company's stock on marginthat is, borrow money
from a broker and use the borrowed funds to pay for a portion of the stockin order to add
15' +hapter 15
to the corporate borrowing. Investors who want less leverage than the company has taken on
can invest a portion of their funds in a risk/free investment to offset some of the corporate
borrowing. %% argued that homemade leverage was a perfect substitute for corporate
borrowing, given their assumptions. )s a result, investors do not care how much debt any
firm has since they can use homemade leverage to ad:ust their overall debt exposure to
precisely reproduce the effect of any level of corporate debt on their returns and risk.
1<. Is =ro$essor 9iller,s personal ta* mo#el relevant in to#ay,s ta* environment %iller's
personal tax model examined the effect of personal income taxes on the debt/e&uity mix
decision. 2e observed that personal income taxes in the 7.$. favor e&uity financing since
profits from e&uity investments come primarily in the form of capital gains which are taxed
later and at potentially lower rates than interest income from debt investments. %iller
determined that the bias in personal income taxes toward e&uity essentially offset the bias
toward debt in the corporate income tax code and concluded that this supported the original
%% conclusion that the financing mix is irrelevant to a company's value. $ince the time
%iller wrote, the difference between the tax rates on ordinary income and capital gains has
narrowed, somewhat weakening his argument. 4ith today's personal tax rate structure, it is
likely that the bias toward debt from the corporate income tax dominates the favoring of
e&uity by personal taxes. 2owever, some politicians continue to advocate for further
reductions in capital gains tax rates! if this happens, we will once again move closer to %iller's
conclusions.
11. 1hat are the variables that enter compromise theory 1hat is the e$$ect o$ each on the
optimal #ebt6e7uity mi* In compromise theory, the value of a levered firm e&uals the
value of the same firm without leverage modified by the impact of three factors6
'*( #orporate income taxes the bias toward debt in the corporate income tax code adds
value to companies with debt financing.
'5( Bankruptcy costs the increased probability of loss should a company be unable to
service its debt subtracts value from companies with debt financing.
'1( )gency costs the increased difficulty of aligning management actions with shareholder
needs in a company with debt subtracts value from companies with debt financing.
1!. "e$ine the meaning o$ each letter o$ 4>?I+TO05 an# give an illustration o$
each. "8I#TO is an acronym summari;ing important issues that affect the debt/e&uity mix
decision in practice6
'*( " < flexibility the impact of alternative financing choices on the firm's future ability to
raise funds in any form re&uired. ) company with flexibility will not be shut out of the
financial markets nor forced to take a type of financing that is not its preferred choice.
'5( 8 < risk the impact of alternative financing choices on the risks faced by the firm and
its stakeholders. In general, taking on additional debt adds to the risks of creditors and
shareholders.
'1( I < income the impact of alternative financing choices on the firm's income stream. )
firm with BIT above the financing indifference point that increases its debt will increase
its earnings per share.
8everage an# the "ebt6E7uity 9i* 155
'0( # < control the impact of alternative financing choices on each shareholder's amount of
control of the firm. In general, selling additional shares of common e&uity will dilute each
shareholder's control.
'+( T < timing the impact of market conditions on alternative financing choices. "inancial
market conditions often favor one or another kind of financing.
'9( O < other the impact of alternative financing choice on other issues and vice versa. )n
example is the ability to use collateral to reduce the cost and risks of debt financing.
1%. 1hat is meant by the 4pec-ing or#er approach5 @ive three e*planations why it is an
observe# phenomenon. The pecking order approach is a se&uence of raising financing that
many companies seem to follow, even though it ignores the recommendations of the various
debt/e&uity/mix theories. The approach is to finance first with retained earnings, second with
payables and bank debt, third with bonds and other more complex debt, and fourth with
common stock issues. Three explanations for the pecking order approach are6
'*( It is the easiest way for financial managers to obtain funds since it re&uires the least
amount of work and limits the need for potentially complex negotiations.
'5( It raises funds in the order of low to high flotation costs, keeping these costs to a
minimum.
'1( The financial markets often take the announcement of a stock sale as negative information,
assuming that management would only sell new shares if its share price were high, hence
the stock was overvalued. 4hen management announces a stock sale, it signals this
previously inside information 'asymmetric information( to the markets. By putting stock
sales last on the list, the financial manager minimi;es the possibility of this reduction in the
firm's share price taking place.
=?O(8E9S
SO8UTION =?O(8E9 151
'a( #onstruct an income statement
$ales =+,>>>,>>>
?ariable costs 5,5+>,>>> 0+, of =+ million
15. +hapter 15
#ontribution 5,@+>,>>>
"ixed costs *,>>>,>>>
BIT *,@+>,>>>
Interest >
BT *,@+>,>>>
Taxes 9*5,+>> 1+, of =*,@+>,>>>
)T *,*1@,+>>
Ashares *,>>>,>>>
-$ =*.*0
"rom the statement6 BIT < =*,@+>,>>>
-$ < =*.*0
'b( 8edo the income statement
$ales up +, $ales down +,
$ales =+,5+>,>>> =0,@+>,>>>
?ariable costs 5,195,+>> 5,*1@,+>> 0+,
#ontribution 5,BB@,+>> 5,9*5,+>>
"ixed costs *,>>>,>>> *,>>>,>>> no change
BIT *,BB@,+>> *,9*5,+>>
Interest > >
BT *,BB@,+>> *,9*5,+>>
Taxes 99>,95+ +90,1@+ 1+,
)T *,559,B@+ *,>0B,*5+
Ashares *,>>>,>>> *,>>>,>>>
-$ =*.51 =*.>+
"rom the statements6
BIT < =*,BB@,+>> =*,9*5,+>>
-$ < =*.51 =*.>+
'c( "or sales up by +,6
BIT went from =*,@+>,>>> to =*,BB@,+>>, an increase of
*,BB@,+>> *,@+>,>>> < @.B9,
*,@+>,>>>
-$ went from =*.*0 to =*.51, an increase of
=*.51 *.*0 < @.B.,
*.*0
8everage an# the "ebt6E7uity 9i* 153
"or sales down by +,6
BIT went from =*,@+>,>>> to =*,9*5,+>>, a decrease of
*,9*5,+>> *,@+>,>>> < @.B9,
*,@+>,>>>
-$ went from =*.*0 to =*.>+, a decrease of
=*.>+ *.*0 < @.B.,
*.*0
'd( In all cases, BIT and -$ change by the same percentage 'within round/off error(. Observe
the following6
'*( $ince this company has fixed operating costs, it has operating leverage. BIT changes
by more than sales '@.B9, vs. +,(.
'5( $ince this company has no fixed financing costs 'no interest(, it has no financial
leverage. -$ changes by the same percentage as BIT.
'1( 3everage is symmetricalthe changes are the same regardless of whether sales is
increasing or decreasing.
SO8UTION =?O(8E9 15!
'a( #onstruct an income statement
$ales =+,>>>,>>>
?ariable costs 1,5+>,>>> 9+, of =+ million
#ontribution *,@+>,>>>
"ixed costs >
BIT *,@+>,>>>
Interest @+>,>>>
BT *,>>>,>>>
15: +hapter 15
Taxes 1+>,>>> 1+, of =* million
)T 9+>,>>>
Ashares *,>>>,>>>
-$ =>.9+
"rom the statement6 BIT < =*,@+>,>>>
-$ < =>.9+
'b( 8edo the income statement
$ales up +, $ales down +,
$ales =+,5+>,>>> =0,@+>,>>>
?ariable costs 1,0*5,+>> 1,>B@,+>> 9+,
#ontribution *,B1@,+>> *,995,+>>
"ixed costs > > still >
BIT *,B1@,+>> *,995,+>>
Interest @+>,>>> @+>,>>>
BT *,>B@,+>> .*5,+>>
Taxes 1B>,95+ 1*.,1@+ 1+,
)T @>9,B@+ +.1,*5+
Ashares *,>>>,>>> *,>>>,>>>
-$ =>.@* =>.+.
"rom the statements6
BIT < =*,B1@,+>> =*,995,+>>
-$ < =>.@* =>.+.
'c( "or sales up by +,6
BIT went from =*,@+>,>>> to =*,B1@,+>>, an increase of
*,B1@,+>> *,@+>,>>> < +.>>,
*,@+>,>>>
-$ went from =>.9+ to =>.@*, an increase of
=>.@* >.9+ < ..51,
>.9+
"or sales down by +,6
BIT went from =*,@+>,>>> to =*,995,+>>, a decrease of
*,995,+>> *,@+>,>>> < +.>>,
*,@+>,>>>
-$ went from =>.9+ to =>.+., a decrease of
=>.+. >.9+ < ..51,
8everage an# the "ebt6E7uity 9i* 15;
>.9+
'd( -$ changes by more than BIT in both cases. Observe the following6
'*( $ince this company has no fixed operating costs, it has no operating leverage. BIT
changes by the same percentage as sales 'both by +.>>,(.
'5( $ince this company has fixed financing costs 'interest(, it has financial leverage. -$
changes by a greater percentage than BIT '..51, vs. +.>>,(.
'1( 3everage is symmetricalthe changes are the same regardless of whether sales is
increasing or decreasing.
SO8UTION =?O(8E9 15%
'a( )lternative A* )lternative A5
BIT *,>>>,>>> *,>>>,>>>
Interest 5+>,>>> 1+>,>>>
BT @+>,>>> 9+>,>>>
Taxes 595,+>> 55@,+>> 1+,
)T 0B@,+>> 055,+>>
Ashares 5>>,>>> *+>,>>>
-$ =5.00 =5.B5
'b( )lternative A* )lternative A5
BIT *,*>>,>>> *,*>>,>>>
Interest 5+>,>>> 1+>,>>>
BT B+>,>>> @+>,>>>
Taxes 5.@,+>> 595,+>> 1+,
)T ++5,+>> 0B@,+>>
Ashares 5>>,>>> *+>,>>>
-$ =5.@9 =1.5+
'c( )lternative A* )lternative A5
BIT .>>,>>> .>>,>>>
Interest 5+>,>>> 1+>,>>>
BT 9+>,>>> ++>,>>>
151< +hapter 15
Taxes 55@,+>> *.5,+>> 1+,
)T 055,+>> 1+@,+>>
Ashares 5>>,>>> *+>,>>>
-$ =5.** =5.1B
'd( )lternative A5 has the greater amount of leverage since it has higher fixed costs 'interest(. In
these examples, BIT is high enough so that )lternative A5 provides the greater amount of
-$, hence the higher returns. But alternative A5 also has the higher level of risk. 7nder
)lternative A*, -$ swings from =5.00 down to =5.**'*1.+5,( and up to =5.@9'C*1.**,(.
7nder )lternative A5, -$ swings from =5.B5 down to =5.1B'*+.9>,( and up to
=1.5+'C*+.5+,(, a greater range in percentage terms. There is a tradeoff here between
returns and risk.
SO8UTION =?O(8E9 15'
'a( )lternative A* )lternative A5
BIT B,>>>,>>> B,>>>,>>>
Interest 5,5+>,>>> 0,>>>,>>>
BT +,@+>,>>> 0,>>>,>>>
Taxes 5,>*5,+>> *,0>>,>>> 1+,
)T 1,@1@,+>> 5,9>>,>>>
Ashares *,>>>,>>> B>>,>>>
-$ =1.@0 =1.5+
'b( )lternative A* )lternative A5
BIT .,5>>,>>> .,5>>,>>>
Interest 5,5+>,>>> 0,>>>,>>>
BT 9,.+>,>>> +,5>>,>>>
Taxes 5,015,+>> *,B5>,>>> 1+,
)T 0,+*@,+>> 1,1B>,>>>
Ashares *,>>>,>>> B>>,>>>
-$ =0.+5 =0.51
'c( )lternative A* )lternative A5
BIT 9,B>>,>>> 9,B>>,>>>
Interest 5,5+>,>>> 0,>>>,>>>
BT 0,++>,>>> 5,B>>,>>>
Taxes *,+.5,+>> .B>,>>> 1+,
8everage an# the "ebt6E7uity 9i* 1511
)T 5,.+@,+>> *,B5>,>>>
Ashares *,>>>,>>> B>>,>>>
-$ =5..9 =5.5B
'd( )lternative A5 has the greater amount of leverage since it has higher fixed costs 'interest(. In
this example, however, BIT is not high enough for )lternative A5 to provide the greater
returns)lternative A5 has lower returns 'lower -$( than )lternative A*. )lso, )lternative
A5 has the higher level of risk. 7nder )lternative A*, -$ swings from =1.@0 down to
=5..9'5>.B9,( and up to =0.+5'C5>.B9,(. 7nder )lternative A5, -$ swings from =1.5+
down to =5.5B'5..B+,( and up to =0.51'C1>.*+,(, a greater range in percentage terms.
)lternative A* is clearly preferable to )lternative A5.
SO8UTION =?O(8E9 155
'a( Try a couple of values for BIT and calculate -$ for each6
-lan )6 BIT < =+>>,>>> -$ < =>
BIT < =1,>>>,>>> -$ < =0.>9
-lan B6 BIT < =B>>,>>> -$ < =>
BIT < =1,>>>,>>> -$ < =+.@5
-lot these points and :oin them with a straight line6
* 5 1
*,1>>,>>>
*
5
1
0
+
9
BIT '=million(
-$ '=(
)
B
'b( 'BIT i
)
('* t( < 'BIT i
B
('* t(
$hares
)
$hares
B
'BIT +>>,>>>('* .1+( < 'BIT B>>,>>>('* .1+(
151! +hapter 15
0>>,>>> 5+>,>>>
0>>,>>>'BIT B>>,>>>( < 5+>,>>>'BIT +>>,>>>(
0>>,>>>BIT 15>,>>>,>>>,>>> < 5+>,>>>BIT *5+,>>>,>>>,>>>
*+>,>>>BIT < *.+,>>>,>>>,>>>
BIT < *,1>>,>>>
'c(
-$ < 'BIT i('* t(
Ashares
7se either alternative, since -$ is the same at this level of BIT. 7sing )lternative )6
-$ < '*,1>>,>>> +>>,>>>('* .1+( < B>>,>>>'.9+( < =*.1>
0>>,>>> 0>>,>>>
'd( 3ooking at the graph, -$ is higher6
-lan ) / left of break/even, i.e., for BIT D =*,1>>,>>>
-lan B / right of break/even, i.e., for BIT E =*,1>>,>>>
SO8UTION =?O(8E9 15.
'a( Try a couple of values for BIT and calculate -$ for each6
-lan F6 BIT < =5,>>>,>>> -$ < =>
BIT < =9,>>>,>>> -$ < =*>.0>
-lan G6 BIT < =*,5>>,>>> -$ < =>
BIT < =9,>>>,>>> -$ < =9..1
-lot these points and :oin them with a straight line6
8everage an# the "ebt6E7uity 9i* 151%

* 5 9
1,>>>,>>>
5
0
9
B
*>
*5
BIT '=million(
-$ '=(
G
F
1 0 +

'b( 'BIT i
F
('* t( < 'BIT i
G
('* t(
$hares
F
$hares
G
'BIT 5,>>>,>>>('* .1+( < 'BIT *,5>>,>>>('* .1+(
5+>,>>> 0+>,>>>
5+>,>>>BIT 1>>,>>>,>>>,>>> < 0+>,>>>BIT .>>,>>>,>>>,>>>
5>>,>>>BIT < 9>>,>>>,>>>,>>>
BIT < 1,>>>,>>>
'c( -$ < 'BIT i('* t(
Ashares
7se either plan, since -$ is the same at this level of BIT. 7sing -lan F6
-$ < '1,>>>,>>> 5,>>>,>>>('* .1+( < *,>>>,>>>'.9+( < =5.9>
5+>,>>> 5+>,>>>
'd( 3ooking at the graph, -$ is higher6
-lan F / right of break/even, i.e., for BIT E =1,>>>,>>>
-lan G / left of break/even, i.e., for BIT D =1,>>>,>>>
SO8UTION =?O(8E9 153
'a( The optimal debt/e&uity mix is the one which minimi;es the cost of capital.
'b(
Hebt -ercent #ost of -ercent #ost of #ost of
151' +hapter 15
ratio ) debt I debt C e&uity I e&uity < capital
>, ) >, 0.>, *>>, *>.+, *>.+>,
*> ) *> 0.> .> **.> *>.1>
5> ) 5> 0.> B> **.9 *>.>B
1> ) 1> 0.5 @> *5.0 ...0

0> ) 0> 0.+ 9> *1.9 ...9
+> ) +> 0.. +> *+.1 *>.*>
9> ) 9> +.0 0> *@.B *>.19
@> ) @> 9.5 1> 5*.+ *>.@.
B> ) B> @.+ 5> 59.> **.5>

'c( The optimal mix is 1>, debt and @>, e&uity. )t this mix, the cost of
capital reaches its minimum value of ...0,.
'd( The traditionalists argue that both debt and e&uity investors increase their re&uired rates of
return as the firm takes on more debt due to the increasing risk they must bear. The change is
slow at first, as a small amount of debt does not cause much risk, but re&uired rates rise more
rapidly as the mix continues to move toward more debt.
SO8UTION =?O(8E9 15:
'a(
Hebt -ercent #ost of -ercent #ost of #ost of
ratio ) debt I debt C e&uity I e&uity < capital
>, ) >, 1.+, *>>, ..>, ..>>,
*> ) *> 1.+ .> ..> B.0+
5> ) 5> 1.+ B> ..5 B.>9
1> ) 1> 1.+ @> ..9 @.@@
0> ) 0> 1.@ 9> *>.5 @.9>

+> ) +> 0.> +> **.0 @.@>
8everage an# the "ebt6E7uity 9i* 1515
9> ) 9> 0.+ 0> *1.> @..>
@> ) @> +.5 1> *+.5 B.5>
B> ) B> 9.5 5> *B.5 B.9>

'b( The optimal mix is 0>, debt and 9>, e&uity. )t this mix, the cost of
capital reaches its minimum value of @.9>,.
'c(
Hebt #ost of #ost of
ratio debt Increase e&uity Increase

>, 1.+,
>
..>,
>
*> 1.+
>
..>

>.5,
5> 1.+
>
..5

>.0,
1> 1.+
>.5,
..9

>.9,
0> 1.@
>.1,
*>.5

*.5,
+> 0.>
>.+,
**.0

*.9,
9> 0.+
>.@,
*1.>

5.5,
@> +.5
*.>,
*+.5

1.>,
B> 9.5 *B.5
The pattern is the same for both debt and e&uity. $mall increases in the debt ratio do not
change creditors' nor stockholders' re&uired returns. 3arger debt ratios raise re&uired returns,
and by an accelerating rate. $tockholders' re&uired rate of return rises faster than creditors' as
they bear more risk.
'd(
Hebt #ost of #ost of
ratio ) e&uity debt < Hifference
>, ) ..>, 1.+, +.+,
*> ) ..> 1.+ +.+
5> ) ..5 1.+ +.@
1> ) ..9 1.+ 9.*
151. +hapter 15
0> ) *>.5 1.@ 9.+
+> ) **.0 0.> @.0
9> ) *1.> 0.+ B.+
@> ) *+.5 +.5 *>.>
B> ) *B.5 9.5 *5.>
These differences confirm the observations of part 'c(. The cost of e&uity rises at a faster rate
than the cost of debt due to the greater risk assumed by stockholders.
SO8UTION =?O(8E9 15;
'a( The compromise theory relationship is6
?
3?8H
< ?
7J3?8H
C #T B# )#
Hebt
ratio ) ?
7J3?8H
C #T B# )# < ?
3?8H
>, ) 1+,>>> > > > 1+,>>>
*> ) *,>>> > 5>> 1+,B>>
5> ) 5,>>> *,>>> 0>> 1+,9>>
1> ) 1,>>> 5,>>> @>> 1+,1>>
0> ) 0,>>> 0,>>> *,*>> 11,.>>
+> ) +,>>> @,>>> *,9>> 1*,0>>
9> ) 9,>>> **,>>> 5,5>> 5@,B>>
@> ) @,>>> *9,>>> 5,.>> 51,*>>
B> ) B,>>> 55,>>> 1,@>> *@,1>>

'b( The optimal mix is *>, debt and .>, e&uity. )t this mix, the value of
the firm reaches its highest 'optimal( value of =1+,B>>,>>>.
'c( The Kacceptable rangeK appears to be from a little over >, debt through about 1>, debt. In
this region, the firm's value seems to hold close to =1+.+ million.
'd( The corporate tax numbers '#T( increase at a constant rate with the debt ratio since they are
related to it in a linear fashion. %ore debt more interest more tax deductions more
present value of tax benefits. The bankruptcy cost 'B#( and agency cost ')#( numbers, on
the other hand, reflect increasing risk perceptions which grow at an accelerating rate as the
debt ratio increases.
SO8UTION =?O(8E9 151<
8everage an# the "ebt6E7uity 9i* 1513
'a( The compromise theory relationship is6
?
3?8H
< ?
7J3?8H
C #T B# )#
Hebt
ratio ) ?
7J3?8H
C #T B# )# < ?
3?8H
>, ) B>,>>> > > > B>,>>>
*> ) 1,>>> > *,>>> B5,>>>
5> ) 9,>>> > *,+>> B0,+>>
1> ) .,>>> 0,>>> 5,5>> B5,B>>
0> ) *5,>>> B,>>> 1,*>> B>,.>>
+> ) *+,>>> *0,>>> 0,5>> @9,B>>
9> ) *B,>>> 55,>>> +,+>> @>,+>>
@> ) 5*,>>> 15,>>> @,>>> 95,>>>
B> ) 50,>>> 00,>>> B,@>> +*,1>>

'b( The optimal mix is 5>, debt and B>, e&uity. )t this mix, the value of
the firm reaches its highest 'optimal( value of =B0,+>>,>>>.
'c( The Kacceptable rangeK appears to be a narrow band around 5>, debt. )t debt ratios away
from 5>,, the firm's value drops off rapidly.
'd( )gency costs arise with the very first dollar of debt since a new stakeholder has been added to
the company. %anagement must integrateLalign the creditors with other stakeholder needs,
creating a potential for loss of value by shareholders. Bankruptcy costs, on the other hand,
only begin when the amount of debt grows large enough to pose default risks.
SO8UTION =?O(8E9 1511
'a( Hebt ratio
Jow < 1,>>>,>>> < 1>,
*>,>>>,>>>
)fter < 1,>>>,>>> C 5,>>>,>>> < +>,
*>,>>>,>>>
'b( There would be =+,>>>,>>> of debt after the change6
)mount -roportion #ost -roportion #ost
1,>>>,>>> 9>, +, 1.>>,
5,>>>,>>> 0>, 9.+, 5.9>
151: +hapter 15
+.9>,
'c( Jow6
-roportion #ost -roportion #ost
Hebt 1>, +, *.+>,
&uity @>, *5, B.0>
...>,
)fter6
Hebt +>, +.9, 5.B>,
&uity +>, *0.>, @.>>
..B>,
'd( Other things e&ual, yes / alter the debt/e&uity mix. This will reduce the cost of capital and
increase the value of the firm.
SO8UTION =?O(8E9 151!
'a( Hebt ratio
Jow < 0>,>>>,>>> < B>,
+>,>>>,>>>
)fter < 0>,>>>,>>> *+,>>>,>>> < +>,
+>,>>>,>>>
'b( #ost of #apital
Jow6
-roportion #ost -roportion #ost
Hebt B>, *>, B.>>,
&uity 5>, *., 1.B>
**.B>,
)fter6
Hebt +>, *>, +.>>,
&uity +>, *5, 9.>>
**.>>,
'c( 8efunding the *>, debt6
Hebt +>, 9, 1.>>,
&uity +>, *5, 9.>>
..>>,
8everage an# the "ebt6E7uity 9i* 151;
'd( Ges / alter the mix and refund the expensive debt. The combined refinancing reduces the cost
of capital from **.B>, to .,, significantly increasing the value of the firm.
15(1
/==EN"IA 15(
Measuring the Degree of Leverage
=?O(8E9S
SO8UTION =?O(8E9 15(1
#onstruct the top lines of the company's income statement6
$ales =1>>,>>>
?ariable cost *5>,>>> 0>, of sales
#ontribution *B>,>>> '* v( < 9>, of sales
Jow continue down the income statement for each case6
'a( " < =>
#ontribution *B>,>>>
"ixed cost >
BIT =*B>,>>>
'b( " < =0>,>>>
#ontribution *B>,>>>
"ixed cost 0>,>>>
BIT =*0>,>>>
'c( " < =B>,>>>
#ontribution *B>,>>>
"ixed cost B>,>>>
BIT =*>>,>>>
'd( " < =*5>,>>>
#ontribution *B>,>>>
"ixed cost *5>,>>>
BIT = 9>,>>>
15(! /ppen#i* 15(
SO8UTION =?O(8E9 15(!
#onstruct the top lines of the company's income statement6
$ales =*,@+>,>>>
?ariable cost *,*1@,+>> 9+, of sales
#ontribution 9*5,+>> '* v( < 1+, of sales
Jow continue down the income statement for each case6
'a( " < =>
#ontribution 9*5,+>>
"ixed cost >
BIT =9*5,+>>
'b( " < =*+>,>>>
#ontribution 9*5,+>>
"ixed cost *+>,>>>
BIT =095,+>>
'c( " < =1>>,>>>
#ontribution 9*5,+>>
"ixed cost 1>>,>>>
BIT =1*5,+>>
'd( " < =0+>,>>>
#ontribution 9*5,+>>
"ixed cost 0+>,>>>
BIT =*95,+>>
SO8UTION =?O(8E9 15(%
9easuring the "egree o$ 8everage 15(%
8edo the income statements of problem *+B* with sales of =0>>,>>>6
'a( 'b( 'c( 'd(
$ales =0>>,>>> =0>>,>>> =0>>,>>> =0>>,>>>
?ariable cost

*9>,>>> *9>,>>> *9>,>>> *9>,>>>

#ontribution 50>,>>> 50>,>>> 50>,>>> 50>,>>>
"ixed cost > 0>,>>> B>,>>> *5>,>>>
BIT =50>,>>> =5>>,>>> =*9>,>>> =*5>,>>>
BIT was *B>,>>> *0>,>>> *>>,>>> 9>,>>>
#hange to BIT = 9>,>>> = 9>,>>> = 9>,>>> = 9>,>>>
%easured in absolute dollars, BIT increases by =9>,>>> in all four cases.
Jote

6 0>, of sales, from problem *+B*

-ercentage change to BIT
'a( =9>,>>>L=*B>,>>> < 11.11, Jote6 greater percentage change with
'b( =9>,>>>L=*0>,>>> < 05.B9, higher fixed costs.
'c( =9>,>>>L=*>>,>>> < 9>.>>,
'd( =9>,>>>L=9>,>>> < *>>.>>,
SO8UTION =?O(8E9 15('
8edo the income statements of problem *+B5 with sales of =5,>>>,>>>6
'a( 'b( 'c( 'd(
$ales =5,>>>,>>> =5,>>>,>>> =5,>>>,>>> =5,>>>,>>>
?ariable cost

*,1>>,>>> *,1>>,>>> *,1>>,>>> *,1>>,>>>

#ontribution @>>,>>> @>>,>>> @>>,>>> @>>,>>>
"ixed cost > *+>,>>> 1>>,>>> 0+>,>>>
BIT = @>>,>>> = ++>,>>> = 0>>,>>> = 5+>,>>>
BIT was 9*5,+>> 095,+>> 1*5,+>> *95,+>>
#hange to BIT = B@,+>> = B@,+>> = B@,+>> = B@,+>>
%easured in absolute dollars, BIT increases by =B@,+>> in all four cases.
Jote

6 9+, of sales, from problem *+B5

15(' /ppen#i* 15(
-ercentage change to BIT
'a( =B@,+>>L=9*5,+>> < *0.5., Jote6 greater percentage change with
'b( =B@,+>>L=095,+>> < *B..5, higher fixed costs.
'c( =B@,+>>L=1*5,+>> < 5B.>>,
'd( =B@,+>>L=*95,+>> < +1.B+,
SO8UTION =?O(8E9 15(5
'*( #onstruct income statements for each sales level6
'a( 'b( 'c( 'd(
$ales =@>>,>>> =B>>,>>> =.>>,>>> =*,>>>,>>>
?ariable cost

1+>,>>> 0>>,>>> 0+>,>>> +>>,>>>

#ontribution 1+>,>>> 0>>,>>> 0+>,>>> +>>,>>>
"ixed cost 1>>,>>> 1>>,>>> 1>>,>>> 1>>,>>>
BIT = +>,>>> =*>>,>>> =*+>,>>> = 5>>,>>>
'5( Increase each sales number by *>, and construct new income statements6
'a( 'b( 'c( 'd(
$ales =@@>,>>> =BB>,>>> =..>,>>> =*,*>>,>>>
?ariable cost

1B+,>>> 00>,>>> 0.+,>>> ++>,>>>

#ontribution 1B+,>>> 00>,>>> 0.+,>>> ++>,>>>
"ixed cost 1>>,>>> 1>>,>>> 1>>,>>> 1>>,>>>
BIT = B+,>>> =*0>,>>> =*.+,>>> = 5+>,>>>
Jote

6 +>, of sales
'1( #ompare BIT levels6
'a( #hange < =B+,>>> =+>,>>> < =1+,>>>
-ercentage change < =1+,>>> < @>.>>,
=+>,>>>
'b( #hange < =*0>,>>> =*>>,>>> < =0>,>>>
-ercentage change < =0>,>>> < 0>.>>,
=*>>,>>>
'c( #hange < =*.+,>>> =*+>,>>> < =0+,>>>
-ercentage change < =0+,>>> < 1>.>>,
=*+>,>>>
'd( #hange < =5+>,>>> =5>>,>>> < =+>,>>>
9easuring the "egree o$ 8everage 15(5
-ercentage change < =+>,>>> < 5+.>>,
=5>>,>>>
4hile the absolute change increases as sales goes up, the percentage change decreases as the
firm's BIT rises.
SO8UTION =?O(8E9 15(.
'*( #onstruct income statements for each sales level6
'a( 'b( 'c( 'd(
$ales =5+>,>>> =1>>,>>> =1+>,>>> =0>>,>>>
?ariable cost

*>>,>>> *5>,>>> *0>,>>> *9>,>>>

#ontribution *+>,>>> *B>,>>> 5*>,>>> 50>,>>>
"ixed cost *5>,>>> *5>,>>> *5>,>>> *5>,>>>
BIT = 1>,>>> = 9>,>>> = .>,>>> =*5>,>>>
'5( Increase each sales number by 5+, and construct new income statements6
'a( 'b( 'c( 'd(
$ales =1*5,+>> =1@+,>>> =01@,+>> =+>>,>>>
?ariable cost

*5+,>>> *+>,>>> *@+,>>> 5>>,>>>

#ontribution *B@,+>> 55+,>>> 595,+>> 1>>,>>>
"ixed cost *5>,>>> *5>,>>> *5>,>>> *5>,>>>
BIT = 9@,+>> =*>+,>>> =*05,+>> =*B>,>>>
Jote

6 0>, of sales
'1( #ompare BIT levels6
'a( #hange < =9@,+>> =1>,>>> < =1@,+>>
-ercentage change < =1@,+>> < *5+.>>,
=1>,>>>
'b( #hange < =*>+,>>> =9>,>>> < =0+,>>>
-ercentage change < =0+,>>> < @+.>>,
=9>,>>>
'c( #hange < =*05,+>> =.>,>>> < =+5,+>>
-ercentage change < =+5,+>> < +B.11,
=.>,>>>
15(. /ppen#i* 15(
'd( #hange < =*B>,>>> =*5>,>>> < =9>,>>>
-ercentage change < =9>,>>> < +>.>>,
=*5>,>>>
4hile the absolute change increases as sales goes up, the percentage change decreases as the
firm's BIT increases.
SO8UTION =?O(8E9 15(3
HO3 < contribution
BIT
"rom problem *+B*6
'a( HO3 < =*B>,>>> < * 4ith no fixed operating costs, HO3 always < *
=*B>,>>>

'b( HO3 < =*B>,>>> < *.5.

=*0>,>>>
)s fixed operating costs rise, BIT declines
'c( HO3 < =*B>,>>> < *.B> relative to contribution, and HO3 rises.
=*>>,>>>

'd( HO3 < =*B>,>>> < 1.>>

= 9>,>>>

In problem *+B1, sales increased to =0>>,>>> 'from =1>>,>>> in problem *+B*(, a 11.11,
increase. )pplying the HO3 numbers from above to the 11.11, change in sales gives the
percentage change in BIT in problem *+B16
'a( 11.11,'*( < 11.11,
'b( 11.11,'*.5.( < 01.>>,, within roundoff of 05.B9,
'c( 11.11,'*.B>( < 9>.>>,
'd( 11.11,'1.>>( < *>>.>>,
SO8UTION =?O(8E9 15(:
HO3 < contribution
BIT
"rom problem *+B56
'a( HO3 < =9*5,+>> < * 4ith no fixed operating costs, HO3 always < *
9easuring the "egree o$ 8everage 15(3
=9*5,+>>

'b( HO3 < =9*5,+>> < *.15

=095,+>>
)s fixed operating costs rise, BIT declines
'c( HO3 < =9*5,+>> < *..9 relative to contribution, and HO3 rises.
=1*5,+>>

'd( HO3 < =9*5,+>> < 1.@@

=*95,+>>

In problem *+B0, sales increased to =5,>>>,>>> 'from =*,@+>,>>> in problem *+B5(, a *0.5.,
increase. )pplying the HO3 numbers from above to the *0.5., change in sales gives the
percentage change in BIT in problem *+B06
'a( *0.5.,'*( < *0.5.,

'b( *0.5.,'*.15( < *B.B9,,
'c( *0.5.,'*..9( < 5B.>*, within roundoff error
'd( *0.5.,'1.@@( < +1.B@,

SO8UTION =?O(8E9 15(;

HO3 < contribution
BIT
-rior to the sales increase6
'a( HO3 < =1+>,>>> < @.>>
= +>,>>>
'b( HO3 < =0>>,>>> < 0.>>
=*>>,>>>
'c( HO3 < =0+>,>>> < 1.>>
=*+>,>>>
'd( HO3 < =+>>,>>> < 5.+>
=5>>,>>>
)fter the sales increase6
'a( HO3 < =1B+,>>> < 0.+1
= B+,>>>
'b( HO3 < =00>,>>> < 1.*0
=*0>,>>>
'c( HO3 < =0.+,>>> < 5.+0
=*.+,>>>
'd( HO3 < =++>,>>> < 5.5>
=5+>,>>>
15(: /ppen#i* 15(
Jote how as sales, hence BIT, rises, HO3 declines.
SO8UTION =?O(8E9 15(1<
HO3 < contribution
BIT
-rior to the sales increase6
'a( HO3 < =*+>,>>> < +.>>
= 1>,>>>
'b( HO3 < =*B>,>>> < 1.>>
= 9>,>>>
'c( HO3 < =5*>,>>> < 5.11
= .>,>>>
'd( HO3 < =50>,>>> < 5.>>
=*5>,>>>
)fter the sales increase6
'a( HO3 < =*B@,+>> < 5.@B
= 9@,+>>
'b( HO3 < =55+,>>> < 5.*0
=*>+,>>>
'c( HO3 < =595,+>> < *.B0
=*05,+>>
'd( HO3 < =1>>,>>> < *.9@
=*B>,>>>
Jote how as sales, hence BIT, rises, HO3 declines.
SO8UTION =?O(8E9 15(11
#onstruct the bottom lines of the company's income statement6
'a( 'b( 'c( 'd(
BIT =+>>,>>> =+>>,>>> =+>>,>>> =+>>,>>>
Interest > *>>,>>> 5>>,>>> 1>>,>>>
BT +>>,>>> 0>>,>>> 1>>,>>> 5>>,>>>
Taxes *@+,>>> *0>,>>> *>+,>>> @>,>>>
)T 15+,>>> 59>,>>> *.+,>>> *1>,>>>
A $hares 5>,>>> 5>,>>> 5>,>>> 5>,>>>
9easuring the "egree o$ 8everage 15(;
-$ = *9.5+ = *1.>> = ..@+ = 9.+>
SO8UTION =?O(8E9 15(1!
#onstruct the bottom lines of the company's income statement6
'a( 'b( 'c( 'd(
BIT =5,+>>,>>> =5,+>>,>>> =5,+>>,>>> =5,+>>,>>>
Interest > +>>,>>> *,>>>,>>> *,+>>,>>>
BT 5,+>>,>>> 5,>>>,>>> *,+>>,>>> *,>>>,>>>
Taxes B@+,>>> @>>,>>> +5+,>>> 1+>,>>>
)T *,95+,>>> *,1>>,>>> .@+,>>> 9+>,>>>
A $hares *+>,>>> *+>,>>> *+>,>>> *+>,>>>
-$ = *>.B1 = B.9@ = 9.+> = 0.11
SO8UTION =?O(8E9 15(1%
8edo the income statements of problem *+B** with BIT of =++>,>>>6
'a( 'b( 'c( 'd(
BIT =++>,>>> =++>,>>> =++>,>>> =++>,>>>
Interest > *>>,>>> 5>>,>>> 1>>,>>>
BT ++>,>>> 0+>,>>> 1+>,>>> 5+>,>>>
Taxes *.5,+>> *+@,+>> *55,+>> B@,+>>
)T 1+@,+>> 5.5,+>> 55@,+>> *95,+>>
A $hares 5>,>>> 5>,>>> 5>,>>> 5>,>>>
-$ = *@.BB = *0.91 = **.1B = B.*1
15(1< /ppen#i* 15(
-$ was =*9.5+ =*1.>> = ..@+ = 9.+>
#hange to -$ = *.91 = *.91 = *.91 = *.91
%easured in absolute dollars, -$ increases by =*.91 in all four cases.
-ercentage change to -$
'a( =*.91L=*9.5+ < *>.>1, '*>, without roundoff error( Jote6 greater percentage
'b( =*.91L=*1.>> < *5.+0, '*5.+>, without roundoff error( change with higher
'c( =*.91L= ..@+ < *9.@5, '*9.9@, without roundoff error( fixed costs 'interest(.
'd( =*.91L= 9.+> < 5+.>B, '5+.>>, without roundoff error(
SO8UTION =?O(8E9 15(1'
8edo the income statements of problem *+B*5 with BIT of =1,>>>,>>>6
'a( 'b( 'c( 'd(
BIT =1,>>>,>>> =1,>>>,>>> =1,>>>,>>> =1,>>>,>>>
Interest > +>>,>>> *,>>>,>>> *,+>>,>>>
BT 1,>>>,>>> 5,+>>,>>> 5,>>>,>>> *,+>>,>>>
Taxes *,>+>,>>> B@+,>>> @>>,>>> +5+,>>>
)T *,.+>,>>> *,95+,>>> *,1>>,>>> .@+,>>>
A $hares *+>,>>> *+>,>>> *+>,>>> *+>,>>>
-$ = *1.>> = *>.B1 = B.9@ = 9.+>
-$ was = *>.B1 = B.9@ = 9.+> = 0.11
#hange to -$ = 5.*@ = 5.*@ = 5.*@ = 5.*@
%easured in absolute dollars, -$ increases by =5.*@ in all four cases.
-ercentage change to -$
'a( =5.*@L=*>.B1 < 5>.>0, '5>, without roundoff error( Jote6 greater percentage
'b( =5.*@L= B.9@ < 5+.>1, '5+, without roundoff error( change with higher
'c( =5.*@L= 9.+> < 11.1B, '11.11, without roundoff error( fixed costs 'interest(.
'd( =5.*@L= 0.11 < +>.*5, '+>, without roundoff error(
SO8UTION =?O(8E9 15(15
'*( #onstruct income statements for each BIT level6
'a( 'b( 'c( 'd(
9easuring the "egree o$ 8everage 15(11
BIT =0>>,>>> =9>>,>>> =B>>,>>> =*,>>>,>>>
Interest 5>>,>>> 5>>,>>> 5>>,>>> 5>>,>>>
BT 5>>,>>> 0>>,>>> 9>>,>>> B>>,>>>
Taxes @>,>>> *0>,>>> 5*>,>>> 5B>,>>>
)T *1>,>>> 59>,>>> 1.>,>>> +5>,>>>
A $hares 1+,>>> 1+,>>> 1+,>>> 1+,>>>
-$ = 1.@* = @.01 = **.*0 = *0.B9
'5( Increase each BIT number by *>, and construct new income statements6
'a( 'b( 'c( 'd(
BIT =00>,>>> =99>,>>> =BB>,>>> =*,*>>,>>>
Interest 5>>,>>> 5>>,>>> 5>>,>>> 5>>,>>>
BT 50>,>>> 09>,>>> 9B>,>>> .>>,>>>
Taxes B0,>>> *9*,>>> 51B,>>> 1*+,>>>
)T *+9,>>> 5..,>>> 005,>>> +B+,>>>
A $hares 1+,>>> 1+,>>> 1+,>>> 1+,>>>
-$ = 0.09 = B.+0 = *5.91 = *9.@*
'1( #ompare -$ levels6
'a( #hange < =0.09 =1.@* < =>.@+
-ercentage change < =>.@+ < 5>.55,
=1.@*
'b( #hange < =B.+0 =@.01 < =*.**
-ercentage change < =*.** < *0..0,
=@.01
'c( #hange < =*5.91 =**.*0 < =*.0.
-ercentage change < =*.0. < *1.1B,
=**.*0
'd( #hange < =*9.@* =*0.B9 < =*.B+
-ercentage change < =*.B+ < *5.0+,
=*0.B9
4hile the absolute change increases as BIT goes up, the percentage change decreases as the
firm's BT rises.
SO8UTION =?O(8E9 15(1.
'*( #onstruct income statements for each BIT level6
15(1! /ppen#i* 15(
'a( 'b( 'c( 'd(
BIT =5+>,>>> =1>>,>>> =1+>,>>> =0>>,>>>
Interest B>,>>> B>,>>> B>,>>> B>,>>>
BT *@>,>>> 55>,>>> 5@>,>>> 15>,>>>
Taxes +.,+>> @@,>>> .0,+>> **5,>>>
)T **>,+>> *01,>>> *@+,+>> 5>B,>>>
A $hares *5,>>> *5,>>> *5,>>> *5,>>>
-$ = ..5* = **..5 = *0.91 = *@.11
'5( Increase each BIT number by 5+, and construct new income statements6
'a( 'b( 'c( 'd(
BIT =1*5,+>> =1@+,>>> =01@,+>> =+>>,>>>
Interest B>,>>> B>,>>> B>,>>> B>,>>>
BT 515,+>> 5.+,>>> 1+@,+>> 05>,>>>
Taxes B*,1@+ *>1,5+> *5+,*5+ *0@,>>>
)T *+*,*5+ *.*,@+> 515,1@+ 5@1,>>>
A $hares *5,>>> *5,>>> *5,>>> *5,>>>
-$ = *5.+. = *+..B = *..19 = 55.@+
'1( #ompare -$ levels6
'a( #hange < =*5.+. =..5* < =1.1B
-ercentage change < =1.1B < 19.@>,
=..5*
'b( #hange < =*+..B =**..5 < =0.>9
-ercentage change < =0.>9 < 10.>+,
=**..5
'c( #hange < =*..19 =*0.91 < =0.@1
-ercentage change < =0.@1 < 15.11,
=*0.91
'd( #hange < =55.@+ =*@.11 < =+.05
-ercentage change < =+.05 < 1*.5B,
=*@.11
4hile the absolute change increases as BIT goes up, the percentage change decreases as the
firm's BT rises.
9easuring the "egree o$ 8everage 15(1%
SO8UTION =?O(8E9 15(13
H"3 < BIT
earnings before taxes
"rom problem *+B**6
'a( H"3 < =+>>,>>> < * 4ith no fixed financing costs 'interest(,
=+>>,>>> H"3 always < *

'b( H"3 < =+>>,>>> < *.5+

=0>>,>>>
)s fixed financing costs 'interest( rise, BT
'c( H"3 < =+>>,>>> < *.9@ declines relative to BIT, and H"3 rises.
=1>>,>>>

'd( H"3 < =+>>,>>> < 5.+>

=5>>,>>>

In problem *+B*1, BIT increased to =++>,>>> 'from =+>>,>>> in problem *+B**(, a *>,
increase. )pplying the H"3 numbers from above to the *>, change in BIT gives the
percentage change to -$ in problem *+B*16
'a( *>,'*( < *>.>>,
'b( *>,'*.5+( < *5.+>,
'c( *>,'*.9@( < *9.9@,
'd( *>,'5.+>( < 5+.>>,
SO8UTION =?O(8E9 15(1:
H"3 < BIT
earnings before taxes
"rom problem *+B*56
'a( H"3 < =5,+>>,>>> < * 4ith no fixed financing costs 'interest(,
=5,+>>,>>> H"3 always < *

'b( H"3 < =5,+>>,>>> < *.5+

=5,>>>,>>>
)s fixed financing costs 'interest( rise, BT
'c( H"3 < =5,+>>,>>> < *.9@ declines relative to BIT, and H"3 rises.
=*,+>>,>>>

'd( H"3 < =5,+>>,>>> < 5.+>

=*,>>>,>>>
15(1' /ppen#i* 15(

In problem *+B*0, BIT increased to =1,>>>,>>> 'from =5,+>>,>>> in problem *+B*5(, a

5>, increase. )pplying the H"3 numbers from above to the 5>, change in BIT gives the
percentage change to -$ in problem *+B*06
'a( 5>,'*( < 5>.>>,
'b( 5>,'*.5+( < 5+.>>,
'c( 5>,'*.9@( < 11.11,
'd( 5>,'5.+>( < +>.>>,
SO8UTION =?O(8E9 15(1;
H"3 < BITMM
earnings before taxes
-rior to the BIT increase6
'a( H"3 < =0>>,>>> < 5.>>
=5>>,>>>
'b( H"3 < =9>>,>>> < *.+>
=0>>,>>>
'c( H"3 < =B>>,>>> < *.11
=9>>,>>>
'd( H"3 < =*,>>>,>>> < *.5+
=B>>,>>>
)fter the BIT increase6
'a( H"3 < =00>,>>> < *.B1
=50>,>>>
'b( H"3 < =99>,>>> < *.01
=09>,>>>
'c( H"3 < =BB>,>>> < *.5.
=9B>,>>>
'd( H"3 < =*,*>>,>>> < *.55
=.>>,>>>
Jote how as BIT, hence BT rises, H"3 declines.
SO8UTION =?O(8E9 15(!<
H"3 < BIT
earnings before taxes
9easuring the "egree o$ 8everage 15(15
-rior to the BIT increase6
'a( H"3 < =5+>,>>> < *.0@
=*@>,>>>
'b( H"3 < =1>>,>>> < *.19
=55>,>>>
'c( H"3 < =1+>,>>> < *.1>
=5@>,>>>
'd( H"3 < =0>>,>>> < *.5+
=15>,>>>
)fter the BIT increase6
'a( H"3 < =1*5,+>> < *.10
=515,+>>
'b( H"3 < =1@+,>>> < *.5@
=5.+,>>>
'c( H"3 < =01@,+>> < *.55
=1+@,+>>
'd( H"3 < =+>>,>>> < *.*.
=05>,>>>
Jote how as BIT, hence BT rises, H"3 declines.
SO8UTION =?O(8E9 15(!1
'a(
$ales =5,>>>,>>>
?ariable cost *,*>>,>>> ++, of sales
#ontribution .>>,>>>
"ixed cost 9>>,>>>
BIT 1>>,>>>
Interest *>>,>>>
BT 5>>,>>>
Taxes @>,>>>
)T *1>,>>>
Ashares *+>,>>>
-$ =>.B@
'b(
HO3 < contribution < =.>>,>>> < 1.>>
BIT =1>>,>>>
15(1. /ppen#i* 15(
H"3 < BIT < =1>>,>>> < *.+>
BT =5>>,>>>
HT3 < contribution < =.>>,>>> < 0.+>
BT =5>>,>>>
'c( HO3 H"3 < 1.>> *.+> < 0.+>
'd(
$ales =5,1>>,>>> up *+,
?ariable cost *,59+,>>> '++, of sales(
#ontribution *,>1+,>>>
"ixed cost 9>>,>>>
BIT 01+,>>> up 0+,
Interest *>>,>>>
BT 11+,>>>
Taxes **@,5+>
)T 5*@,@+>
Ashares *+>,>>>
-$ =*.0+ up 9@,
"rom HO3, BIT should increase by *+,'1.>>( < 0+,
"rom H"3, -$ should increase by 0+,'*.+>( < 9@.+, 'roundoff error(
"rom HT3, -$ should increase by *+,'0.+>( < 9@.+,
SO8UTION =?O(8E9 15(!!
'a(
$ales =+>>,>>>
?ariable cost *@+,>>> 1+, of sales
#ontribution 15+,>>>
"ixed cost *5+,>>>
BIT 5>>,>>>
Interest +>,>>>
BT *+>,>>>
Taxes +5,+>>
)T .@,+>>
Ashares @+,>>>
-$ =*.1>
9easuring the "egree o$ 8everage 15(13
'b(
HO3 < contribution < =15+,>>> < *.91
BIT =5>>,>>>
H"3 < BIT < =5>>,>>> < *.11
BT =*+>,>>>
HT3 < contribution < =15+,>>> < 5.*@
BT =*+>,>>>
'c( HO3 H"3 < *.91 *.11 < 5.*@
'd(
$ales =95+,>>> up 5+,
?ariable cost 5*B,@+> '1+, of sales(
#ontribution 0>9,5+>
"ixed cost *5+,>>>
BIT 5B*,5+> up 0>.9,
Interest +>,>>>
BT 51*,5+>
Taxes B>,.1B
)T *+>,1*5
Ashares @+,>>>
-$ =5.>> up +1..,
"rom HO3, BIT should increase by 5+,'*.91( < 0>.B, 'roundoff error(
"rom H"3, -$ should increase by 0>.9,'*.11( < +0.>, 'roundoff error(
"rom HT3, -$ should increase by 5+,'5.*@( < +0.1, 'roundoff error(*@