Key Issues
Key Issues
Key Issues
A (30% debt)
$3,000,000
10%
70,000 shares
13%
B (50% debt)
$5,000,000
12%
40,000 shares
18%
These structures are based on maintaining the firms current level of $10,000,000 of total
financing.
Lawson expects the firms earnings before interest and taxes (EBIT) to remain at its current
level of $1,200,000. The firm has a 40% tax rate.
Required:
a. Use the current level of EBIT to calculate the times interest earned ratio for each capital
structure. Evaluate the current and two alternative capital structures using the times interest
earned and debt ratios.
b. Prepare a single EBITEPS graph showing the current and two alternative capital
structures.
1
c. On the basis of the graph in part b, which capital structure will maximize Tampas earnings
per share (EPS) at its expected level of EBIT of $1,200,000? Why might this not be the best
capital structure?
d. Using the zero-growth valuation model given in Equation 12.12, find the market value of
Tampas equity under each of the three capital structures at the $1,200,000 level of expected
EBIT.
e. On the basis of your findings in parts c and d, which capital structure would you
recommend? Why?
Key Issues (a): Use the current level of EBIT to calculate the times interest earned ratio for
each capital structure. Evaluate the current and two alternative capital structures using the
times interest earned and debt ratios.
Alternative A 30%
Alternative B 50%
Debt
Debt
Debt
$1,000,000
$3,000,000
$5,000,000
Coupon rate
0.09
0.10
0.12
Interest
$ 90,000
$ 300,000
$ 600,000
EBIT
$1,200,000
$1,200,000
$1,200,000
Interest
$ 90,000
$ 300,000
$ 600,000
13.33
Comment:
As the debt ratio increases from 10% to 50%, so do both financial leverage and risk. At 10%
debt and $1,200,000 EBIT, the firm has over 13 times coverage of interest payments; at 30%,
it still has 4 times coverage. At 50% debt, the highest financial leverage, coverage drops to 2
times, which may not provide enough cushions. Both the times interest earned and debt ratios
should be compared to those of the printing equipment industry.
Key Issues (b): Prepare a single EBITEPS graph showing the current and two alternative
capital structures.
EBIT
$600,000
$1,200,000
$600,000
$1,200,000
$600,000
$1,200,000
Interest
90,000
90,000
300,000
300,000
600,000
600,000
EBT
$510,000
$1,110,000
$300,0
$ 900,000
$0
$ 600,000
Taxes40%
204,00
444,000
120,000
360,000
240,000
EAT
$306,000
$ 666,00
$180,000
$ 540,000
$0
$ 360,000
EPS
$ 3.06
$ 6.66
$ 2.57
$ 7.71
$ 9.00
100,000 Shares
70,000 Shares
40,000 Shares
Comment:
We see that the graph shows that EBIT in the X axis and EPS in the Y axis. When debt was
10% debt than EPS was $6.66 and 30% debt the EPS $7.71 and when 50% debt it shows $9.
Key Issues (c): On the basis of the graph in part b, which capital structure will maximize
Tampas earnings per share (EPS) at its expected level of EBIT of $1,200,000? Why might
this not be the best capital structure?
Analysis: If Tampa Manufacturings EBIT is $1,200,000, EPS is highest with the 50% debt
ratio. The steeper slope of the lines representing higher debt levels demonstrates that financial
leverage increases as the debt ratio increases. Although EPS is highest at 50%, the company
must also take into consideration the financial risk of each alternative. The drawback to the
EBIT-EPS approach is its emphasis on maximizing EPS rather than owners wealth. It does
not take risk into account. Also, if EBIT falls below about $750,000 (intersection of 10% and
30% debt), EPS is higher with a capital structure of 10%.
Key Issues (d): Using the zero-growth valuation model given in Equation 12.12, find the
market value of Tampas equity under each of the three capital structures at the $1,200,000
level of expected EBIT.
P0=EPS r s
Key Issues (e): On the basis of your findings in parts c and d, which capital structure would
you recommend? Why?
Analysis: Alternative A, 30% debt, appears to be the best alternative. Although EPS is
higher with Alternative B, the financial risk is high; times interest earned is only 2 times.
6
Alternative A has a moderate risk level, with 4 times coverage of interest earned, and
provides increased market value. Choosing this capital structure allows the firm to benefit
from financial leverage while not taking on too much financial risk.
RECOMMENDATION
From the above calculation of Tampa Manufacturing Companys debt ratio and time interest
ratio given 13.33 times, 4 times, and 2 times when debt 10%, 30% and 50% debt. So it is best
to take capital stricture alternative A because these capital structure is moderate risk for the
company and EPS is satisfactory. Though 50% debts is highest EPS and maximize owners
wealth. So company can consider alternative A capital structure.
CONCLUSION
Tampa Manufacturing Companys chose current capital structure than it earns EAT $6,
66,000 with $6.66 EPS and chose alternative A capital structure than earns $5,40,000 EAT
with $ 7.71 EPS and alternative B capital structure than earns $360000 EAT with $9 EPS.
8
Alternative A also 4 time coverage of interest earned and yester than Alternative B. it also
maximize the companys wealth than Alternative B.
REFERENCE
www.tompa.manufacturing.com/
http://users.rowan.edu/~pritchard/2008%20solutions/Gitman_IM_ch11.pdf
Principles-of-Managerial-Finance- tenth edition-by-Gitman
9
Name
Slide
10
Report
Part
2015210004083
compactions
Analysis
complete
2015210004082
Analysis
2015210004033
Analysis
2014210001025
Analysis
2015210004085
Analysis
11