Principles of Managerial Finance

(Dana P.) #1

550 PART 4 Long-Term Financial Decisions


LG4

LG5

The firm has fixed operating costs of $75,000 and variable operating costs equal
to 70% of the sales level. The company pays $12,000 in interest per period. The
tax rate is 40%.
a. Compute the earnings before interest and taxes (EBIT) for each level
of sales.
b. Compute the earnings per share (EPS) for each level of sales, the expected
EPS, the standard deviation of the EPS, and the coefficient of variation of
EPS, assuming that there are 10,000 shares of common stock outstanding.
c. Tower has the opportunity to reduce leverage to zero and pay no interest.
This will require that the number of shares outstanding be increased to
15,000. Repeat part bunder this assumption.
d. Compare your findings in parts band c,and comment on the effect of the
reduction of debt to zero on the firm’s financial risk.

12 – 18 EPS and optimal debt ratio Williams Glassware has estimated, at various debt
ratios, the expected earnings per share and the standard deviation of the earn-
ings per share as shown in the following table.

a. Estimate the optimal debt ratio on the basis of the relationship between earn-
ings per share and the debt ratio. You will probably find it helpful to graph
the relationship.
b. Graph the relationship between the coefficient of variation and the debt ratio.
Label the areas associated with business risk and financial risk.

12 – 19 EBIT–EPS and capital structure Data-Check is considering two capital struc-
tures. The key information is shown in the following table. Assume a 40%
tax rate.

Source of capital Structure A Structure B

Long-term debt $100,000 at 16% coupon rate $200,000 at 17% coupon rate
Common stock 4,000 shares 2,000 shares

Debt ratio Earnings per share (EPS) Standard deviation of EPS

0% $2.30 $1.15
20 3.00 1.80
40 3.50 2.80
60 3.95 3.95
80 3.80 5.53

Sales Probability

$200,000 .20
300,000 .60
400,000 .20
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