Problems

1. Money Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest
and taxes [EBIT] are projected to be $14,000 if economic conditions are normal. If there is a strong
expansion in the economy, then EBIT will be 30% higher. If there is a recession, then EBIT will be 60%
lower. Money is considering a $60,000 debt issue with a 5% interest rate. The proceeds will be used to
repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem.
Calculate earnings per share [EPS] under each of the three economic scenarios before any debt is issued.
Also calculate the % changes in EPS when the economy expands or enters a recession.

2. Calculate the Degree of Operating Leverage (DOL), Degree of Financial leverage (DFL) and the Degree
of Combined Leverage (DCL) for the following firms and interpret the results.

                                                  Firm A                Firm B               Firm C

Output (units)                        60,000                       15,000                    1,00,000

Fixed Costs (Rs)                    7,000                        14,000                         1,500

Variable cost per unit (Rs.)    0.20                            1.50                            0.02

Interest on borrowed funds   4,000                          8,000                          -----

Selling price per unit (Rs)     0.60                            5.00                         0.10

3. The data relating to two companies are as given below:

                                                   Company A                      Company B

Capital                                         Rs.6,00,000                   Rs.3,50,000

Debentures                                  Rs. 4,00,000                      6,50,000

Output (units) per annum                   60,000                         15,000

Selling price/unit                                Rs.30                              250

Fixed costs per annum                    7,00,000                       14,00,000

Variable cost per unit                           10                                  75

You are required to calculate the Operating leverage, Financial leverage and Combined Leverage of two
companies.

4. Copybold Corporation is a start-up firm considering two alternative capital structures--one is

conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25,
while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it
envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent
probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent
chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative
capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt
cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax
rate, and the book value of equity per share under either scenario is $10.00 per share.

a. What is the difference between the EPS forecasts for Feast and Famine under the aggressive capital
structure?

b. What is the difference between the EPS forecasts for Feast and Famine under the conservative capital
structure?

5. Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $100,000, and its variable
costs are equal to fifty cents for every dollar of sales. The company has $1,000,000 in debt outstanding
at a before-tax cost of 10 percent. If Bell Brothers' sales were to increase by 20 percent, how much of a
percentage increase would you expect in the company's net income?

6. A firm expects to have a 15 percent increase in sales over the coming year. If it has operating leverage
equal to 1.25 and financial leverage equal to 3.50, then what will be the percentage change in EPS?

7. Emerson Co. Ltd wants to take up a new project that requires a capital of $ 15, 00, 000. Interest on
Debt is 12 % and the Tax rate is 30 %. The company is contemplating either an all equity financing or
financing in debt equity ratio of 2:1, where the equity shares are going can be issued at $ 50 (par value).
Assuming no incidence of taxes, calculate the EBIT-EPS Indifference point.

8. Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 20 lakhs of external financing
for which it is considering two alternatives. The first alternative calls for issuing 15,000 equity shares of
Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the second alternative requires 10,000
equity shares of Rs 100 each, 2,000 10% Preference Shares of Rs 100 each and Rs 8,00,000 Debentures
carrying 9% interest. The company is in the tax bracket of 50%. You are required to calculate the
indifference point for the plans and verify your answer by calculating the EPS.

Solution

1. Under Normal Economic Conditions

EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60

Under Expansionary Times:

EPS = [EBIT x 1.60]/shares outstanding = $14,000(1.3)/2,500 $18,200/2,500 = $7.28

Under a Recession:

EPS = [EBIT x (1-.60)]/shares outstanding =$14,000(.40)/2,500 $5,600/2,500 = $2.24

% Δ EPS going from Normal  Expansion: ($7.28 - $5.60)/$5.60 = .30 or 30% %

Δ EPS going from Normal  Recession: ($2.24 - $5.60)/$5.60 = -.60 or -60%

2.                                        Firm A                Firm B               Firm C

Output (units)                        60,000                    15,000               1,00,000

Selling price per unit (Rs)      0.60                            5.00                    0.10

Variable cost per unit (Rs.)    0.20                            1.50                     0.02

Contribution per unit          0.40                            3.50                    0.08

Total Contribution         Rs.24,000                 Rs.52,500             RS.8,000

Less fixed costs                     7,000                        14,000                   1,500

EBIT                                    17,000                         38,500                   6,500

Less Interest                         4,000                           8,000                      ---

Profit before Tax                 13,000                         30,500                    6,500

Degree of Operating Leverage

Contribution/EBIT 24,000/17,000 52,500/38,000 8,000/6,500

= 1.41 =1.36 = 1.23

Degree of Financial Leverage

EBIT/PBT 17,000/13,000 38,500/30,500 6,500/6,500

= 1.31 = 1.26 = 1.00

Degree of Combined Leverage

Contribution/ EBIT 24,000/13,000 52,500/30,500 8,000/6,500

= 1.85 = 1.72 = 1.23

3.                                              Company A                                          Company B

Output (units) per annum                 60,000                         15,000

Selling price/unit                                Rs.30                              250

Sales Revenue                                18,00,000                         37,50,000

Less variable costs

@ Rs.10 and Rs.75                        6,00,000                        11,25,000

Contribution                                 12,00,000                       26,25,000

Less fixed costs                            7,00,000                       14,00,000

EBIT                                            5,00,000                        12,25,000

Less Interest @ 12%

on debentures                               48,000                             78,000

PBT                                             4,52,000                         11,47,000

DOL  = Contribution/EBIT   12,00,000/5,00,000        26,25,000/12,25,000

                                                      = 2.4                                =  2.14

DFL = EBIT/ PBT      5,00,000/4,52,000         12,25,000/11,47,000

=1.11                               =1.07

DCL = DOL x DFL         2.14 x 1.11 = 2.66           2.14 x 1.07 = 2.2

4.a. Debt = 75% = $300,000; Equity = 25% = $100,000; Total assets = $400,000.

Feast Famine
Probability 0.6 0.4
EBIT $60,000   $20,000
Interest (36,000) (36,000)
EBT $24,000 ($16,000)  
Taxes (9,600) 6,400
NI $14,400 ($ 9,600)  
# shares 10,000 10,000
EPS $1.44 -$0.96

Difference in EPS for aggressive capital structure:

EPSFeast - EPSFamine = $1.44 - ($0.96) = $2.40.
b. Debt = 25% = $100,000; Equity = 75% = $300,000; Total assets = $400,000.
Feast Famine
Probability 0.6 0.4
EBIT $60,000   $20,000  
Interest (10,000) (10,000)
EBT $50,000 $10,000  
Taxes (20,000) 4,000
NI $30,000 ($6,000)
# shares 30,000 30,000
EPS $1.00 $0.20
 Difference in EPS for conservative capital structure:
EPSFeast - EPSFamine = $1.00 - $0.20 = $0.80.

5.

Step 1: Find Degree of Total Leverage (DTL):

DTL =
S−V $ 3,000,000−0.5( $ 3,000,000)
= =1.1538
S−V −F−I $ 3,000,000−0.5 ( $ 3,000,000 )−$ 100,000−0.1($ 100,000)

Step 2: Find percentage increase in net income:

%NI = (0.20) (DTL) = (0.20) (1.1538) = 0.2308 = 23.08%.
6.
DTL = DOL  DFL = (1.25)(3.50) = 4.375
%EPS = %Sales  DTL = (0.15)(4.375) = 65.63%

7. So, there are 2 alternatives to the capital investment:" Debt and Equity " or just " Equity "

Option 1: All Equity Financing

No. of shares (with equity of $ 15, 00, 000) = 15, 00, 000/50 = 30, 000

Option 2: Debt -Equity Financing in ratio of 2:1

Debt and Equity, required for second option:

Debt = $ 10, 00,000, Equity = $ 5, 00,000

Interest on debt, 12 % = 10,00,000 *12/100 = 1, 20, 000

No. of shares (with equity of $ 5, 00, 000) = 5, 00, 000/50 = 10, 000

Calculation of the indifference point:

Without Debt, the EPS would be: (EBIT - 0)/30000

With Debt, the EPS would be: (EBIT - 1,20,000)/10, 000

The indifference EBIT is obtained when the alternatives are equated:

(EBIT - 0)/30000 = (EBIT - 120000)/10000

Solving it, we get:

EBIT = $ 3, 60, 000

8.