CHAPTER 12 Leverage and Capital Structure 555c. Calculate the annual interest on the debt under each of the capital structures
being considered. (Note:The before-tax cost of debt, kd, is the interest rate
applicable to alldebt associated with the corresponding debt ratio.)
d. Calculate the EPS associated with each of the three levels of EBIT calculated
in part afor each of the five capital structures being considered.
e. Calculate (1) the expected EPS, (2) the standard deviation of EPS, and (3) the
coefficient of variation of EPS for each of the capital structures, using your
findings in part d.
f. Plot the expected EPS and coefficient of variation of EPS against the capital
structures (xaxis) on separate sets of axes, and comment on the return and
risk relative to capital structure.
g. Using the EBIT–EPS data developed in partd,plot the 0, 30, and 60% capital
structures on the same set of EBIT–EPS axes, and discuss the ranges over which
each is preferred. What is the major problem with the use of this approach?
h. Using the valuation model given in Equation 12.12 and your findings in part
e,estimate the share value for each of the capital structures being considered.
i. Compare and contrast your findings in parts fand h.Which structure is pre-
ferred if the goal is to maximize EPS? Which structure is preferred if the goal
is to maximize share value? Which capital structure do you recommend?
Explain.CHAPTER 12 CASE Evaluating Tampa Manufacturing’s Capital Structure
T
ampa Manufacturing, an established producer of printing equipment,
expects its sales to remain flat for the next 3 to 5 years because of both a
weak economic outlook and an expectation of little new printing technology
development over that period. On the basis of this scenario, the firm’s manage-
ment has been instructed by its board to institute programs that will allow it to
operate more efficiently, earn higher profits, and, most important, maximize
share value. In this regard, the firm’s chief financial officer (CFO), Jon Lawson,
has been charged with evaluating the firm’s capital structure. Lawson believes
that the current capital structure, which contains 10% debt and 90% equity,
may lack adequate financial leverage. To evaluate the firm’s capital structure,
Lawson has gathered the data summarized in the following table on the current
capital structure (10% debt ratio) and two alternative capital structures—A
(30% debt ratio) and B (50% debt ratio)—that he would like to consider.Capital structurea
Current A B
Source of capital (10% debt) (30% debt) (50% debt)Long-term debt $1,000,000 $3,000,000 $5,000,000
Coupon interest rateb 9% 10% 12%
Common stock 100,000 shares 70,000 shares 40,000 shares
Required return on equity, ksc 12% 13% 18%
aThese structures are based on maintaining the firm’s current level of $10,000,000 of total financing.
bInterest rate applicable to alldebt.
cMarket-based return for the given level of risk.