430 Part 5 Capital Structure and Dividend Policy
but (3) the sales price on all units would have to be lowered to $95 to permit sales of the
additional output. Olinde has tax loss carry-forwards that cause its tax rate to be zero, it
uses no debt, and its average cost of capital is 10%.
a. Should Olinde make the change? Why or why not?
b. Would Olinde’s break-even point increase or decrease if it made the change?
c. Suppose Olinde were unable to raise additional equity financing and had to borrow
the $400,000 at an interest rate of 10% to make the investment. Use the DuPont equa-
tion to find the expected ROA of the investment. Should Olinde make the change if
debt financing must be used? Explain.
FINANCIAL LEVERAGE Gentry Motors Inc., a producer of turbine generators, is in this
situation: EBIT " $4 million, tax rate " T " 35%, debt outstanding " D " $2 million,
rd " 10%, rs " 15%, shares of stock outstanding " N 0 " 600,000, and book value per share "
$10. Because Gentry’s product market is stable and the company expects no growth, all
earnings are paid out as dividends. The debt consists of perpetual bonds.
a. What are Gentry’s earnings per share (EPS) and its price per share (P 0 )?
b. What is Gentry’s weighted average cost of capital (WACC)?
c. Gentry can increase its debt by $8 million to a total of $10 million, using the new debt
to buy back and retire some of its shares at the current price. Its interest rate on debt
will be 12% (it will have to call and refund the old debt), and its cost of equity will
rise from 15% to 17%. EBIT will remain constant. Should Gentry change its capital
structure? Why or why not?
d. If Gentry did not have to refund the $2 million of old debt, how would this affect the
situation? Assume that the new and the still outstanding debt are equally risky, with
rd " 12%, but that the coupon rate on the old debt is 10%.
e. What is Gentry’s TIE coverage ratio under the original situation and under the condi-
tions in Part c of this question?Changes in sales cause changes in profits. Would the profit change associated with sales
changes be larger or smaller if a firm increased its operating leverage? Explain your
answer.
Would each of the following increase, decrease, or have an indeterminant effect on a
firm’s break-even point (unit sales)?
a. The sales price increases with no change in unit costs.
b. An increase in fixed costs is accompanied by a decrease in variable costs.
c. A new firm decides to use MACRS depreciation for both book and tax purposes
rather than the straight-line depreciation method.
d. Variable labor costs decline; other things are held constant.
Discuss the following statement: All else equal, firms with relatively stable sales are able
to carry relatively high debt ratios. Is the statement true or false? Why?
If Congress increased the personal tax rate on interest, dividends, and capital gains but
simultaneously reduced the rate on corporate income, what effect would this have on the
average company’s capital structure?
Which of the following would likely encourage a firm to increase the debt in its capital
structure?
a. The corporate tax rate increases.
b. The personal tax rate increases.
c. Due to market changes, the firm’s assets become less liquid.
d. Changes in the bankruptcy code make bankruptcy less costly to the firm.
e. The firm’s sales and earnings become more volatile.
Why do public utilities generally use different capital structures than pharmaceutical
companies?
Why is EBIT generally considered independent of financial leverage? Why might EBIT
actually be affected by financial leverage at high debt levels?