MANAGEMENT CONSULTANCY - Solutions Manual
CHAPTER 18 LONG-TERM FINANCING DECISIONS I.
Questions 1. Both operati operating ng and financia financiall leverag leveragee imply imply that the firm will will employ employ a heavy component component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy. 2. Debt can can only only be used used up to a point. point. Beyond Beyond that, financial financial leverage leverage tends to increase the overall costs of financing to the firm as well as encourage credito creditors rs to place place restriction restrictionss on the firm. The limitat limitation ionss of using using financial leverage tend to be greatest in industries that are highly cyclical in nature. 3. Operating leverage leverage primarily affects the operating income income of the the firm. At this point, financial leverage takes over and determines the overall impact on earnings per share. 4. At progressively progressively higher higher levels levels of of operation operation than the the break-even break-even point, point, the percentage percentage change in operating income income as a result of a percentage percentage change in unit volume volume diminishes. diminishes. The reason is primarily mathematical -- as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less. 5. The point point of equality equality only only measures measures indiff indifferen erence ce based based on earnings earnings per share. Since our ultimate ultimate goal is market market value maximization maximization,, we must also be concerned concerned with how how these earnings earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt. debt.
6. From a purely purely econ econom omic ic view viewpo point int,, a firm shoul should d not not ration ration capital. capital. The firm should should be able to find find additi additiona onall funds funds and increase increase its overal overalll profitability profitability and wealth through through accepting investments investments to the point where marginal return equals marginal cost. II. Multiple Choice 1. D
6. C 18-1
Chapter 18
2. 3. 4. 5.
Long-term Financing Decisions
D B A A
7. B 8. B
III. Problems PROBLEM 1 (UNION BUSINESS FORMS)
Cost (after-tax) 7.05 10.0
Weights 35% 15
13.0
50
Debt (K d)..................................... Preference shares (K p)................. Ordinary equity (K e) retained earnings................... Weighted average cost of capital (K a)
Weighted Cost 2.45% 1.50 6.50 10.45%
PROBLEM 2 (HOLLY CORP.)
Weighted average cost of capital Debt Preference Shares Ordinary Shares
=
6.60% x 30% = = 9.11% x 10% = 11.0% x 60% = WACC
1.98% = 0.90% 6.60% 9.48%
PROBLEM 3 (UNION BRICK)
The optimal capital budget is P230,000 (Projects A, B, and C). All the projects’ IRR exceeded the average marginal cost.
PROBLEM 4 (PIZZA EXPRESS)
k sp =
10% + 1.38 (5%) = 16.9%.
k ap =
0.5 (12.0%) (0.6) + 0.5 (16.9%) = 12.05%.
But k p = IRR = 13.0%. 18-2
Long-term Financing Decisions
Chapter 18
Accept the project, its required rate of return is 12.05%.
PROBLEM 5 (HAPPY GILMORE CO.)
Debt
=
12.4% (1 - 35%) = 8.06% x 35%
Q (P - VC) Preference Shares = Q (P - VC) - FC - I
x 10%
=
2.82%
=
0.98%
10,000 (P50 - P20) Ordinary Shares = + 12% x 55% = 9.35% 10,000 (P50 - P20) - P150,000 - P60,000 Weighted average cost of capital
13.15%
P4.75 PROBLEM 6 (SNOWBELL COMPANY) P50 - P1.40
a.
Q = 10,000, P = P50, VC = P20, FC = P150,000, I = P60,000 P2.70 Q (P - VC) P54 DOL = Q (P - VC) - FC =
10,000 (P50 - P20) 10,000 (P50 - P20) - P150,000
=
10,000 (P30) 10,000 (P30) - P150,000
=
b. DFL
=
=
c.
DCL
300,000 P300,000 - P150,000
EBIT EBIT - I P150,000 P90,000
300,000 P150,000
P150,000 P150,000 - P60,000
=
=
=
1.67X
=
= 18-3
=
2.00X
Chapter 18
Long-term Financing Decisions
=
d. BE
=
=
=
=
=
3.33X
5,000 skates
PROBLEM 7 (PILAK COMPANY)
a.
INCOME STATEMENTS Return on assets = 10% 10,000 (P30) 10,000 (P30) - P210,000
Current EBIT P1,200,000 P150,000 Less: Interest 600,000 1 P50 - P20 EBT 600,000 Less: Taxes (45%) 270,000 EAT 330,000 Ordinary shares 750,000 4 EPS P0.44 1 2 3 4
EBIT = P1,200,000 P300,000 P90,000
Plan D P1,200,000 P150,000 960,000 2 P30 240,000 108,000 132,000 375,000 P0.35
Plan E P1,200,000 300,000 3 900,000 405,000 495,000 1,125,000 P0.44
P6,000,000 debt @ 10% P600,000 interest + (P3,000,000 debt @ 12%) (P6,000,000 - P3,000,000 debt retired) x 10% (P6,000,000 ordinary equity) / (P8 par value) = 750,000 shares Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is equal to the operating return on assets of 10 percent. With Plan D, the cost of increased debt rises to 12 percent, and the firm incurs negative leverage reducing EPS and also increasing the financial risk to Pilak.
b. Return on assets
EBIT Less: Interest EBT Less: Taxes (45%) EAT Ordinary shares EPS
= 5%
EBIT
Current P600,000 600,000 0 0 750,000 0
=
Plan D P 600,000 960,000 (360,000) (162,000) P(198,000) 375,000 P(0.53) 18-4
P600,000 Plan E P600,000 300,000 300,000 135,000 P165,000 1,125,000 P0.15
Long-term Financing Decisions
Return on assets = 15%
EBIT Less: Interest EBT Less: Taxes (45%) EAT Ordinary shares EPS
EBIT
Current P1,800,000 600,000 1,200,000 540,000 P 660,000 750,000 P0.88
Plan D P1,200,000 960,000 840,000 378,000 P 462,000 375,000 P1.23
=
Chapter 18
P1,800,000 Plan E P1,800,000 300,000 1,500,000 675,000 P 825,000 1,125,000 P0.73
If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides the best EPS. Plan D is still risky, having an interest coverage ratio of less than 2.0. c. Return on assets
EBIT EAT Ordinary shares EPS 1
2
= 10%
EBIT
Current P1,200,000 P 330,000 750,000 P0.44
Plan D P1,200,000 P 132,000 1 500,000 P0.26
=
P1,200,000 Plan E P1,200,000 P 495,000 2 1,00,000 P0.50
750,000 - (P3,000,000 / P12 per share) = 750,000 - 250,000 = 500,000 750,000 + (P3,000,000 / P12 per share) = 750,000 + 250,000 = 1,000,000
As the price of the ordinary shares increases, Plan E becomes more attractive because fewer shares can be retired under Plan D and, by the same logic, fewer shares need to be sold under Plan E.
18-5
