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Chapter 14 Questions 1. The user of leverage might be thought of as taking advantage of the provider. Between Stockholders and Bondholders, who is the user, and who is the provider? Give a word explanation or illustration that might support this view. What does the used party get in return? 2. The central issue underlying the study of leverage is whether or not it influences stock price and whether there's an optimal structure. But the whole idea seems kind of fuzzy and uncertain. Why are people so interested? 6. Briefly explain the pros and cons of financial leverage. In other words, what are its benefits, and what are the costs that come along those benefits Problems 4. Watson Waterbed Works Inc. has an EBIT of $2.75 million, can borrow at 15% interest, and pays combined state and federal income taxes of 40%. It currently has no debt and is capitilized by equity of $12 million. The firm has 1.5 million shares of common stock outstanding the trade at book value. a. Calculate Watson's net income, ROE, and EPS currently and at capital structures that have 20%, 40%, 60%, and 80% debt. b. Compare the EPS at the different leverage levels, the amount of change between levels as leverage increases. What happens to the effect of more debt as leverages increases from a little to a lot? 5. The Tannenbaum Tea Company wants to show the stock market an EPS of $3 per share, but doesn't expect to be able to improve profitability over what is reflected in the financial plan for next year. The plan is partially reproduced below. Tannenbaeum Tea Company Financial Projection 20X1 $0 EBIT $18,750Debt $13,000 Interest (@ 12%) 1,560Equity97,000 EBT $17,190$17,190Capital$110,000 Tax (@ 40%) 6,876 Net Income$10,314Number of Shares3,700,000 Tannenbaeum's stock sells at book value. Will trading equity for debt help the firm achieve its EPS goal, and if so, what debt level will produce the desired EPS? 7. Balfour Corp. has the following operating results and capital structure ($000): Revenue $6,000Debt$1,200 Cost/Expense4,500Equity8,800 EBIT$1,500Total10,000 The firm is contemplating a capital restructuring to %60 debt. Its stock is currently selling for book value at $25 per share. The interest rate is 9% and combined state and federal taxes are 42%. a. Calculate EPS under the current and proposed capital structures b. Calculate the DFL under both structures c. Use the DFLs to forecast the resulting EPS under each structure if operating profit falls off by 5%, 10%, or 25% d. Comment on the desirability of the proposed structure versus the current one as a function of the volatility of the business. e. Is stock price likely to be increased by a change to the proposed capital structure? Discuss briefly. 9. You're a financial analyst AT Pinkerton Interactive Graphic Systems (PIGS) a successful entrant in a new and rapidly growing field. As in most fields, however, rapid growth is anything but ensured, and PIGS's future performance is uncertain. The firm expects to earn operating profits of $4 million next year, up from $1 million last year. To support this enormous growth, the firm plans to raise $15 million in new capital. It already has capitaal of $5 million that is 40% debt. PIGS can raise the new money in any proportion of debt and equity management chooses. The CFO is considering three possibilities: all equity, $8 million debt and $7 million equity, and all debt. Interest on the current debt as well as on new borrowing is expected to be 10% and the company pays state and federal income taxes at a combined rate of 40%. Equity will be raised by selling stock at the current market price of $10, which is equal to its book value. The CFO has asked you to prepare an analysis to aid management in making the debt/equity decision. You are also to provide a recommendation of your own. a. Prepare an EBIT-EPS analysis of the situation showing a line for the capital structure that results from each of the three options. (Calculate EPS under each new capital structure at EBIT levels of $1 million, $2 million, and $4 million. Then graph EBIT versus EPS for each option. Refer to figure 14-3. Show last year's EPS on the graph.) b. Discuss the effect the options might have on stock price. c. Make a subjective recommendation under each of the following assumptions about the $4 million operating profit forecast. Support your position with words and references to your EBIT-EPS analysis. 1. The $4 million operating profit projection is a best case scenario. Anything from $2 million to $4 million has an equal probability of occuring. 2. The $4 million is a fair estimate with about a 60% probability. However, performance better than $4 million is unlikely. Results could range anywhere from zero to $4 million. 3. The $4 million is an easy target. There's an even chance of anything between $4 million and $8 million. 10. Cranberry Wood Prroducts Inc. spends an average of $9.50 in labor and $12.40 in materials on every unit it sells. Sales, commissions and shipping amount to another $3.10. All other costs are fixed and add up to $140,000 per month. The average unit sells for $32.00. a. What are Cranberry's contribution and contribution margin? b. What is the firm's breakeven points in units? c. Calculate the dollar breakeven point in two ways. d. Sketch the breakeven diagram. 16. The Spitfire Model Airplane Company has the following modified income statement ($000) at 100,000 units of production: Revenue10,000 Variable Cost6,500 Fixed Cost2,200 EBIT $1,300 Interest (@ 10%)500 EBIT 800 Tax (@ 40%)320 Net Income$480 Number of Shares20,000 a. What are Spitfire's contribution margin and dollar breakeven point? b. Calculate Spitfire's current DFL, DOL, and DTL. c. Calculate the current EPS and estimate what it would become is sales declined by 25%. Use the DTL first and then recalculate the modified income statement. (Assume a negative EBT generates a negative tax.) Chapter 15 Business Analysis Business Analysis 4Your pal, Fred Flinderbinder, came into class this morning grinning from ear to ear. It seems a stock in which he advised his parents to invest is doing fabulously well. Fred said the firm usually pays a dividend of $2 a share, which is about 4% of its recent $50 market price. Yesterday, however, his folks got a letter that said the cash dividend was being passed, but instead the firm was issuing a stock dividend of 1 share for every 10 owned. Fred calculates that's worth the equivalent of $5 a share, two and a half times the normal cash dividend! Fred has told you all this knowing you're taking finance. He's asked you what you think, obviously expecting praise and approval. What would you say to Fred? Problems Problem 8 You own 1,000 shares of Jennings Corp. stock, which is currently selling for $88. Calculate the number of shares you would own and the stock's market price after each of the following stocks splits. a. A two-for-one stock split. b. A three-for-one stock split. c. A three-for-two stock split d. A three-for-four reverse stock split e. A five-for-three stock split Problem 11Wysoki Enterrprises is considering a stock dividend. The firm's capital includes 3 million shares of $1 par value stock issued at an average price of $8. Retained earnings total $20 million. State the equity accounts now and after each of the following possible stock dividends. a. Wysoki declared a 5% stock dividend, and the current price of stock is $15 b. Wysoki declared a 10% stock dividend, and the current price of is $20 c. Wysoki declared a 15% stock dividend, and the currrent price of the stock is $23 Problem 13The Featherstone Corp. has $8 million in cash for its next dividend but is considering a repurchase instead. Featherstone has 10 million shares outstanding, currently selling at $40 per share. The P/E is 20 on EPS of $2. a. If the dividend is paid, how large will it be per share? b. If stock is repurchased how many shares will remain outstanding, and what will the new EPS be? c. If the P/E holds at 20, what will be the new stock price, and how much per share will continuing in stockholders have gained? How does that compare with the dividend that could have been paid? d. Are there other considerations (words only)?