Problem 1 (22 marks):
The current income statement for Halifax Tire Inc. is provided below.
Interest ($10,000,000 at 9%)
Tax (at 40%)
Earnings After Tax (Net Income)
- Calculate the degree of operating leverage. (2 marks)
- Calculate the degree of financial leverage. (2 marks)
- Calculate the degree of combined leverage. (2 marks)
- What percentage change in EBIT would result from a 10% decrease in sales? What percentage change in EPS would result from a 10% decrease in sales? (4 marks)
- Assuming the company has 200,000 shares issued and outstanding. What would the new EPS be as a result of the 10% decrease in sales? (4 marks)
- Halifax Tire has an objective to lower its degree of combined leverage to 3. Assuming the degree of operating leverage is kept unchanged, by how much should Halifax Tire reduce its debt level to achieve the new degree of combined leverage target? (8 marks)
Problem 2 (18 marks):
SNC Inc. is considering a large investment of $20,000,000 in a new project. The company currently has $15,000,000 of 6% coupon bonds and 2,000,000 common shares outstanding. The tax rate is 40%. Discussions with an investment banker have assured the firm that the following options are feasible:
- Option 1: Sell $20,000,000 worth of common stock at $50 per share.
- Option 2: Issue $10,000,000 worth of 8% coupon bonds with a 30-year maturity, in addition to $10,000,000 worth of common stock at $50 per share.
- Calculate the EBIT indifference point for the 2 options.(12 marks)
- What is the EPS at the EBIT indifference point? At EBIT levels above the EBIT indifference point, which plan would you favour? (6 marks)
Problem 3 (20 marks)
Groceries Inc. has an unlevered cost of equity is 12% and a pre-tax cost of debt of 6%. Both the book and the market value of debt is $500,000. Earnings before interest and taxes (EBIT) are $200,000 (constant in perpetuity) and the tax rate is 40%. Assume there is no cost of financial distress. What is the company’s weighted average cost of capital? Show our work.
Problem 4 (40 marks):
You are the CFO of Laval Inc., an unlevered firm with constant EBIT of $4,000,000 per year in perpetuity. You are considering the use of some debt financing to repurchase shares. You have developed the following schedule based on the PV of bankruptcy costs of $10,000,000:
Value of Debt
Probability of financial distress
The current cost of equity is 12%, and the tax rate is 40%. Assume that the company can borrow at a cost of 6%.
a) What is Laval’s market value and the WACC before any debt is taken on? (6 marks)
b) According to M&M’s case (world) II, what is Laval’s optimal level of debt? (4 marks)
c) What is the optimal capital structure when financial distress costs are included? (18 marks)
d) Compute the WACC at the optimal capital structure determined in part (c). (12 marks)