410 Part 5 Capital Structure and Dividend Policy
Section I. Zero Debt
Debt ratio 0%
Assets $200,000
Debt $ 0
Equity $200,000
Shares outstanding 10,000Effects of Financial Leverage: Bigbee Electronics Financed
with Zero Debt or 50% DebtTabl e 13 - 2Demand For
Product
(1)Probability
(2)EBIT
(3)Interest
(4)Pretax
Income
(5)Taxes
(40%)
(6)Net
Income
(7)ROE
(8)EPSa
(9)
Terrible 0.05 ($ 60,000) $0 ($ 60,000) ($24,000) ($36,000) (18.00)% ($3.60)
Poor 0.20 (20,000) 0 (20,000) (8,000) (12,000) (6.00) (1.20)
Normal 0.50 40,000 0 40,000 16,000 24,000 12.00 2.40
Good 0.20 100,000 0 100,000 40,000 60,000 30.00 6.00
Wonderful 0.05 140,000 0 140,000 56,000 84,000 42.00 8.40
Expected value $ 40,000 $0 $ 40,000 $16,000 $24,000 12.00% $2.40
Standard deviation 14.82% $2.96
Coefficient of variation 1.23 1.23
Section II. 50% Debt
Debt ratio 50.00%
Assets $200,000
Debt $100,000
Interest rate 12.00%
Equity $100,000
Shares outstanding 5,000
Demand For
Product
(1)Probability
(2)EBIT
(3)Interest
(4)Pretax
Income
(5)Taxes
(40%)
(6)Net
Income
(7)ROE
(8)EPSa
(9)
Terrible 0.05 ($ 60,000) $12,000 ($ 72,000) ($28,800) ($43,200) (43.20)% ($8.64)
Poor 0.20 (20,000) 12,000 (32,000) (12,800) (19,200) (19.20) (3.84)
Normal 0.50 40,000 12,000 28,000 11,200 16,800 16.80 3.36
Good 0.20 100,000 12,000 88,000 35,200 52,800 52.80 10.56
Wonderful 0.05 140,000 12,000 128,000 51,200 76,800 76.80 15.36
Expected value $ 40,000 $12,000 $ 28,000 $11,200 $16,800 16.80% $3.36
Standard deviation 29.64% 5.93
Coefficient of variation 1.76 1.76
Assumptions: 1. In terms of its operating leverage, Bigbee has chosen Plan B. The probability distribution and EBIT are obtained from Figure 13-2.- Sales and operating costs (and hence EBIT) are not affected by the financing decision. Therefore, EBIT under both financing
plans is identical and is taken from the EBIT column for Plan B in Figure 13-2. - All losses can be carried back to offset income in the prior year.
a The EPS figures can also be obtained using the following formula in which the numerator amounts to an income statement at a given sales level
displayed horizontally:
EPS! (Sales __" Fixed costs "Shares Variable (^) outstanding costs " Interest)(1 " Tax rate)! (^) Shares (EBIT "outstanding I) (1 " T)
For example, with zero debt and sales " $200,000, EPS is $2.40:
EPSD/A! 0! ($200,000 ____" $60,000 10,000" $100,000 " 0)(0.6)! $2.40
With 50% debt and sales! $200,000, EPS is $3.36:
EPSD/A! 0.5! ($200,000 ___" $60,000 "5,000 $100,000 " $12,000)(0.6)! $3.36
Refer to the tabular data given in Figure 13-2 to arrive at sales, fixed costs, and variable costs that are used in the preceding equations.
Note: Because the demand for the product has a normal distribution, the probability distribution is symmetrical. Consequently, the expected
values equal the values under normal demand. This would not occur under an asymmetrical probability distribution.