Stock and Debt

CHAPTER 12 QUESTIONS12-1Operating supplement affects EBIT and, through EBIT, EPS. Financial supplement mostly has no imprint on EBITit only affects EPS, apt(p) EBIT. 12-2Beca single- evaluated function Firm A has a high frozen in opeproportionn(p)(a) exists, its operational income pass on change by a greater lot than Firm Bs operating(a) income if gross gross revenue change. Firm A has a higher(prenominal) degree of operating leverage than Firm B. 12-3If gross sales tend to fluctuate widely, then cash f low-pitcheds and the mogul to service fixed charges similarly go outing vary. Consequently, t here is a comparatively large assay of infection that the sign will be unable to cogitate its fixed charges.As a burden, flyings in unstable industries tend to wont slight debt than those whose sales argon subject to only moderate fluctuations. 12-4The tax turn a profits from debt enlarge linearly, which ca functions a continuous make up in the immobiles surve y and striving set. However, bankruptcy-related costs begin to be felt after few amount of debt has been employed, and these costs offset the benefits of debt. See Figure 12-5 in the text sacred scripture. 12-5Carson does deport leverage because its EPS join ons by a greater multiple than its sales when sales change. According to the learning that is given, Carsons DTL is 4 = 20/5.Because we have no selective information about either the regulars operating fixed costs or its fixed financing costs, we bottom of the inning non state whether the home has operating leverage, financial leverage, or both. 12-6EBIT depends on sales and operating costs that gener anyy atomic number 18 not affected by the firms use of financial leverage, because participation is deducted from EBIT. At high debt levels, however, firms lose bank line, employees worry, and ope proportionalityns argon not continuous because of financing unwieldyies. Thus, financial leverage can cast sales and co st, hence EBIT, if excessive leverage causes investors, customers, and employees to be oncerned about the firms future. 12-7Expected EPS generally is measured as EPS for the coming years, and we typically do not hypothesize in this calculation any bankruptcy-related costs. Also, EPS does not reflect (in a major way) the adjoin in risk and ks that accompanies an increase in the debt symme tense up, whereas P0 does reflect these operators. Thus, the stock certificate determine will be maximized at a debt level that is demoralise than the EPS-maximizing debt level. 12-8A firm can change the rivaliser of debt it uses in its uppercase body construction. If the firm has too much (little) debt, it can down (increase) the proportion of debt in its outstanding structure.Such as change should decrease the firms WACC, and thus increase its value. 12-9Absolutes optimal upper-case letter structure is 40 part debt (= $20,000,000/$50,000,000), because the mart bell of the high soc ietys stock ($130. 75) is maximized at this point. 12-10With increased competition after the breakup of AT&T, the cutting AT&T and the seven Bell operating companies line of work risk increased. With this role of heart and soul company risk increasing, the refreshed companies probably decided to keep down their financial risk, and use little debt, to compensate.With increased competition the chance of bankruptcy increases and lowering debt usage makes this less of a possibility. If we consider the tax expel alone, disport on debt is tax deductible thus, the higher the firms tax rate the to a greater extent(prenominal) beneficial the deductibility of kindle is. However, competition and logical argument risk have tended to outweigh the tax aspect as we saw from the actual debt ratios of the Bell companies. The Bell companies and the new AT&T displace their debt ratios, for reasons along these lines. 2-11Several possibilities exist for the firm, precisely trying to match the length of the envision with the maturity of the financing plan seems to be the crush approach. The firm skill want to pay the R&D with short-term debt and then, if the projects results argon successful, to assemble the needed capital for production through long-run debt or paleness. Another possibility would be to trend convertible bonds, which can be converted to common stocka lower interest rate would be paid now, and in the future (presumably the stock legal injury will increase with the new process) investors would trade in the bonds for stock.One also should detention in mind that this project, and R&D in general, is extremely forged and debt financing might not be available except at extremely high rates. For this reason, many R&D companies have low debt ratios, instead paying low dividends and using retained earnings for financing projects. Under Debt financing the pass judgment EPS is $5. 78, the standard deviation is $1. 05, the CV is 0. 18, and the debt ra tio increases to 75. 5%. (The debt ratio had been 70. 6 percent. Under Equity financing the expected EPS is $5. 51, the standard deviation is $0. 85, the CV is 0. 15, and the debt ratio decreases to 58. 8 percent. At this interest rate, debt financing provides a higher expected EPS than equity financing however, the debt ratio is importantly higher under the debt financing situation as compargond with the equity financing situation. Because EPS is not significantly greater under debt financing, and the risk is noticeably greater, equity financing should be recommended.INTEGRATIVE PROBLEM adjudicate Business risk is the incertitude associated with a firms projection of its future operating income.It also is defined as the risk faced by a firms stockholders if the company uses no debt. A firms telephone circuit risk is affected by many factors, including (1) variability in the hold for its product, (2) variability in the outlay at which its output can be sold, (3) variability in the prices of its inputs, (4) the firms ability to coiffure output prices as input prices change, (5) the amount of operating leverage used by the firm, and (6) special risk factors (such as potential product liability for a drug company or the potential cost of a thermonuclear accident for a utility with nuclear plants).ANSWER Operating leverage is the extremity to which fixed operating costs atomic number 18 used in a firms operations. If a high percentage of the firms total operating costs be fixed, and hence do not decline when take in falls, then the firm is said to have high operating leverage. assorted things held ceaseless, the greater a firms operating leverage, the greater its business risk. pic ANSWER Financial leverage refers to the firms decision to finance with fixed-charge securities, such as debt and preferred stock. Financial risk is the additional risk, everyplace and above the companys inherent business risk, orne by the stockholders as a result of the firms decision to finance with debt. pic ANSWER As we discussed above, business risk depends on a number of factors such as sales and cost variability, and operating leverage. Financial risk, on the other hand, depends on only one factorthe amount of fixed-charge capital (financing) the company uses. pic ANSWER Here be the full completed statements The expected TIE would be larger than 2. 5x if less debt were used, but smaller if leverage were increased. pic ANSWER The optimal capital structure is the capital structure at which the tax-related benefits of leverage are exactly offset by debts risk-related costs.At the optimal capital structure, (1) the total value of the firm is maximized, (2) the WACC is minimized, and the price per assign is maximized. pic ANSWER Here is the sequence of events 1. CDSS must first report its recapitalization plans. 2. The companys stock would have whatsoever market price before the announcement, in this case, $20 per share. The company would have to estimate (a) the price it would have to pay for the repurchased shares and (b) the method to be used for the repurchase (open market purchases, or a tender offer). 3.For simplicity, we assume that the firm could repurchase stock at its current price, $20, which also happens to be its book value per share. In actuality, investors would probably reassess their views about the firms profitability and risk under the new capital structure, and the stock price probably would rise. No current shareholder would be willing to sell at a price very far down the stairs the expected new price, although some would be afraid the recap plan might not go through, and those stockholders would sell out at a lower-than-expected price.Therefore, the stock price would adjust quickly to a new equilibrium that reflects the recapitalization. 4. CDSS would purchase stock, then issue debt and use the proceeds to pay for the repurchased stock. After the recapitalization, the company would have to a greate r extent debt but fewer common shares outstanding. A new EPS could be metrical, and the price would settle into its new level. pic4. ANSWER The analysis for the debt levels being considered (in thousands of dollars and shares) is shown below At Debt = $0 pic At Debt = $250,000 Shares repurchased = $250,000/$20 = 12,500.Remaining shares outstanding = coke,000 12,500 = 87,500. Note EPS and TIE calculations are in thousands of dollars. ) pic At Debt = $500,000 Shares repurchased = $500,000/$20 = 25,000. Remaining shares outstanding = 100,000 25,000 = 75,000. (Note EPS and TIE calculations are in thousands of dollars. ) pic At Debt = $750,000 Shares repurchased = $750,000/$20 = 37,500. Remaining shares outstanding = 100,000 37,500 = 62,500. (Note EPS and TIE calculations are in thousands of dollars. ) pic At Debt = $1,000,000 Shares repurchased = $1,000,000/$20 = 50,000. Remaining shares outstanding = 100,000 50,000 = 50,000. (Note EPS and TIE calculations are in thousands of doll ars. pic pic ANSWER We can calculate the price of a constant growth stock as DPS divided by rs minus g, where g is the expected growth rate in dividends pic Because in this case all earnings are paid out to the stockholders, DPS = EPS. Further, because no earnings are plowed back, the firms EBIT is not expected to grow, so g = 0.Here are the results Debt Level DPS rs Stock Price $ 0 $3. 00 15. 0% $20. 00 250,000 3. 26 15. 5 21. 03 500,000 3. 56 16. 5 21. 58* 750,000 3. 86 18. 0 21. 44 1,000,000 4. 8 20. 0 20. 40 * maximum ANSWER A capital structure with $500,000 of debt produces the highest stock price, $21. 58, hence it is the best of those considered. ANSWER We have seen that EPS continues to increase beyond the $500,000 optimal level of debt. Therefore, focusing on EPS when making capital structure decisions is not correctwhile the EPS does take account of the differential cost of debt, it does not account for the increasing risk that must be borne by the equity holders. ANSWER Currently, Debt/Total assets = 0%, so total assets = initial equity = $20 x 100,000 shares = $2,000,000.WACC = ($500,000/$2,000,000)(11%)(0. 60) + ($1,500,000/$2,000,000)(16. 5%) = 1. 65% + 12. 38% = 14. 03%. NOTE If we had (1) used the equilibrium price for repurchasing shares and (2) used market value weights to calculate WACC, then we could be sure that the WACC at the price-maximizing capital structure would be the minimum. Using a constant $20 purchase price, and book value weights, inconsistencies might creep in. pic ANSWER If the firm had higher business risk, then, at any debt level, its probability of financial distress would be higher.Investors would secern this, and both rd and rs would be higher than originally estimated. It is not shown in this analysis, but the end result would be an optimal capital structure with less debt. Conversely, lower business risk would lead to an optimal capital structure that included much debt. ANSWER The three degrees of leverage are cal culated below S = $1,350,000 New debt = $500,000 11% VC = 0. 6S F = $40,000 (Note Calculations are in thousands of dollars. ) pic pic DTL = DOL x DFL = 1. 08 x 1. 12 = 1. 21. The degree of operating leverage is defined as the percentage change in perating income (EBIT) associated with a given percentage change in sales. Because our companys degree of operating leverage is 1. 08, this means that a given percentage increase in sales will lead to an 8 percent greater increase in EBIT. For example, if sales increased by 100 percent, then EBIT would increase by 108 percent. The degree of financial leverage is defined as the percentage change in EPS associated with a given percentage change in EBIT. Because CDSSs degree of financial leverage is 1. 12, this means that if EBIT increased by 100 percent, then EPS would increase by 112 percent.The degree of total leverage shows the combined effects of operating and financial leverage on the firms earnings per share. It is defined as the perce ntage change in EPS brought about by a given percentage change in sales, and it is calculated as DOL x DFL. Because CDSSs DTL is 1. 21, a 100 percent increase in sales would produce a 121 percent increase in EPS. The degree of leverage concept is useful for grooming purposes, as it gives an idea of what will happen to earnings as sales vary. Investors can use the concept to consider firms with different leverages if they expect sales to rise or fall. picANSWER Because it is difficult to quantify the capital structure decision, managers consider the following judgmental factors when making capital structure decisions (1)The average debt ratio for firms in their industry. (2)Pro forma tie ratios at different capital structures under different scenarios. (3)Lender/rating agency attitudes. (4)Reserve borrowing capacity. (5)Effects of financing on control. (6)Asset structure. (7)Expected tax rate. ANSWER The following figure presents a graph of the situation pic The use of debt permits a firm to obtain tax savings from the deductibility of interest.So the use of some debt is rock-steady however, the possibility of bankruptcy increases the cost of using debt. At higher and higher levels of debt, the risk of bankruptcy increases, bringing with it costs associated with potential financial distress. Customers reduce purchases, key employees leave, and so on. There is some point, generally well below a debt ratio of 100 percent, at which problems associated with potential bankruptcy more than offset the tax savings from debt. Theoretically, the optimal capital structure is prepare at the point where the marginal tax savings just equal the marginal bankruptcy-related costs.However, analysts cannot identify this point with precision for any given firm, or for firms in general. Analysts can help managers determine an optimal range for their firms debt ratios, but the capital structure decision still is more judgmental than based on precise calculations. ANSWER The asymm etric information concept is based on the premise that managements prime(prenominal) of financing gives signals to investors. Firms with good investment opportunities will not want to share the benefits with new stockholders, so they will tend to finance with debt. Firms with poor prospects, on the other hand, will want to finance with stock.Investors know this, so when a large, mature firm announces a stock offering, investors take this as a signal of bad news, and the stock price declines. Firms know this, so they try to avoid having to sell new common stock. This means maintaining a maintain of borrowing capacity so that when good investments come along, they can be financed with debt. 12-17Computer-Related Problem a. If the outstanding debt has to be refunded at the new higher interest rate, expected EPS would decline under either financing plan. However, EPS would decline more if debt financing were used. Therefore, ebt financing has become relatively less attractive than sto ck financing. The output generated by the model is given belowETHICAL dilemma A BOND IS A BOND IS A STOCK IS A BONDOCK?Ethical dilemma Wally is evaluating whether to use a new (to the United States) financial instrument to rhytidectomy bills to finance Ohio Rubber & Tires (ORT) working out plans. The new instrument, which is called a bondock, has some characteristics of tralatitious debt and some characteristics that are similar to common equity. The cost of capital associated with bondocks is slightly higher than traditional debt, but significantly lower than common equity.If ORTs expansion plans are successful, both its bondholders and its stockholders will receive handsome returns. However, if the expansion plans are not successful, then it get alongs that stockholders can still benefit but at the spending of bondholders. ORTs executives are some of the companys major stockholders, so it appears that they would be in favor of issuing bondocks. Discussion questions ?Is th ere an honest problem? If so, what is it? The question here is whether it is appropriate to use a new financial instrument called a bondock to raise funds needed for expansion.Because the cost of capital associated with a bondock is slightly higher than the cost of debt but significantly lower than the cost of equity, management thinks that it might be appropriate to use this medium to raise funds to invest in risky ventures. If the expansion investment is successful, both the bondholders and the stockholders will benefit. Of course, the benefit to stockholders will be greater than the benefit to bondholders. On the other hand, if the expansion investment is unsuccessful, both bondholders and stockholders will suffer financial losses.But, because the market values of the bondocks will decline significantly, the firm could benefit by repurchasing these financing instruments in the capital markets. In this case, stockholders would benefit at the expense of bondholders. As a result, t he ethical question is whether ORT should raise funds using bondocks knowing that there is a possibility that its stockholders will gain at the expense of its bondholders. ?Is it appropriate for ORT to use bondocks to raise funds that are needed for expansion? Is there an ethical dilemma here? Maybe not. Remember that investors take risks when purchasing the stocks and bonds of firms.In this case, ORT would be wise to use bondocks if the purpose is to raise funds for expansion while trying to lower the cost of capital associated with going to the financial markets. It might be argued that it is wrong for ORT to use bondocks if the intent is to benefit executives who receive bonuses and incentives in the form of the companys stock. It also might be argued that it is unethical if the intent is to malign the position of bondholders.However, if the primary objective is to increase the value of the firm, then it is difficult to argue that issuing this new financial instrument is unethi cal. What would you do if you were Wally? It seems that the best solution is for Wally to try to get more information about the new financial instrument called a bondock. Because little is known about bondocks and they appear to be rather complex financial instruments, Wally should gather more information about the risks as well as the benefits to ORT associated with using this medium to raise funds for expansion. Once he has performed his due diligence, Wally should determine whether using bondocks will benefit the firm and its investors in general.If the answer is no, then bondocks should not be used. References The following articles might be assigned for background material Emily Thornton, Gluttons at the Gate, BusinessWeek, October 30, 2006, pp. 58-66. David Henry, Cross-Dressing Securities, BusinessWeek, March 13, 2006, pp. 58-59