ACF 103 – Fundamentals of Finance

Tutorial 10 - Solutions
Chapter 16
1. FJM International is planning to finance a $20 million capital improvement
program with half debt and half common stock. New shares can be sold for
$25 a share, and the debt will carry a 12% interest rate. FJM currently has an
all-equity capital structure with 1 million shares outstanding. If the firm has a
50% tax rate, and expects an EBIT of $5 million, earnings per share will be
________.
A. $1.20
* B. $1.36
C. $1.78
D. $1.90
Explanation: $20 million new funds needed – 50/50 equity and debt.
Therefore new equity = $10 million/25 = 400,000 new shares
Total shares issued = 1,400,000
New debt = $10,000,000 x 0.12 = $1,200,000 interest
EBIT = 5,000,000
Less interest 1,200,000
EBT 3,800,000
Tax (50%) 1,900,000
Earnings 1,900,000
EPS = 1,900,000/1,400,000 = $1.357

2. McIndustries currently has 500,000 shares of common stock outstanding at a

market price of $40 a share, and $10 million in 8% bonds. The company needs
to raise $10 million in order to implement a series of investment projects. This
amount can be raised by either (1) issuing 250,000 new shares of common at
$40 a share, or (2) selling bonds with a 10% yield. If the firm's tax rate is 50%,
and the EBIT with the new projects is projected at $4 million, which
alternative will result in the highest earnings per share?
* A. debt
B. common stock
C. both alternatives will result in the same EPS
D. cannot tell without additional information
Proof:
Issue new shares = 750,000 total outstanding
EBIT = 4,000,000
Less tax 800,000
EBT 3,200,000
Tax 1,600,000
Earnings 1,600,000
EPS = 1,600,000/750,000 = $2.13

New debt = 10,000,000

Interest (10%) = 1,000,000
+ existing (8%)= 800,000
Total interest = 1,800,000

EBIT = 4,000,000

ACF 103 HAUT 2014 Tutorial Solns 1

 Less interest = 1,800,000
EBT = 2,200,000
Tax = 1,100,000
Earnings = 1,100,000
EPS = 1,100,000/500,000 = $2.20

3. Text book Ch 16, problem # 1 (p.444)

Answer :
a. Q = $880,000/$200 = 4,400 units
$24,000 = [Q(P – V) –FC](1 – t)
$24,000 = [4,400($200 – $150) – FC](0.60)
$24,000 = $132,000 – FC(0.60)
FC = $180,000

b. QBE = $180,000/($200 –$150) = 3,600 units

SBE = 3,600($200) = $720,000
or, alternatively –
SBE = $180,000/[1 – ($150/$200)] = $720,000

c. DOL4,000 units = 4,000/(4,000 – 3,600) = 10.0

DOL4,400 units = 4,400/(4,400 – 3,600) = 5.5
DOL4,800 units = 4,800/(4,800 – 3,600) = 4.0
DOL5,200 units = 5,200/(5,200 – 3,600) = 3.25
DOL5,600 units = 5,600/(5,600 – 3,600) = 2.8
DOL6,000 units = 6,000/(6,000 – 3,600) = 2.5

ACF 103 HAUT 2014 Tutorial Solns 2

d. The graph shows that the sensitivity of a firm’s operating profit to changes in
sales decreases further, as the firm operates above its break-even point. The
company is operating close to its break-even point. Therefore, at its current
monthly sales level of 4,400 units, its sensitivity to sales changes is quite high.
Its DOL at 4,400 units is 5.5 – meaning any percent change in operating
profits will be 5.5 times as large as the percent change in sales that causes it.

4. Text book Ch 16, problem # 2 (p.444)

Answer:
a. QBE = $180,000/($250 – $150) = 1,800 units
b. QBE = $160,000/($200 – $150) = 3,200 units
c. QBE = $240,000/(4200 – $140) = 4,000 units

5. Lincoln Manufacturing has fixed costs (e.g., depreciation) of $40,000 directly

attributable to producing a particular product. The product sells for $2 a unit
and variable costs are $1.20.

What is the break-even point in units produced?

If the firm sold 100,000 units last year and expects volume to increase by
10%, what percentage increase in profits would Lincoln see with this increase
in volume?

What is the Degree of Operating Leverage (DOL) at 100,000 units? At

110,000 units?

Answer:
QBE = $40,000/($2 - $1.20) = 50,000 units.

At volume of 100,000 units:

Profit = (100,000)($2) - $40,000 - (100,000)($1.20) = $40,000

At volume of 110,000 units:

Profit = (110,000)($2) - $40,000 - (110,000)($1.20) = $48,000

Therefore, the percentage increase in profit equals ($48,000 - $40,000)/

$40,000 = 20%

DOL100,000 = (EBIT + FC) / EBIT = ($40,000 + $40,000)/$40,000 = 2.00.

DOL110,000 = (EBIT + FC) / EBIT = ($48,000 + $40,000)/$48,000 = 1.83.

6. The Blue Boat Company currently has 2 million shares of common stock
outstanding, along with $5 million in 10% bonds. The firm is considering a
$10 million expansion program which will be financed with either
(1) all common stock at $50 a share, or
(2) all bonds at a 12% interest rate.
If the projected level of EBIT is $4 million and the firm's tax rate is 40%,
which alternative will yield the higher EPS?
Answer
For alternative #1 (the bonds):

ACF 103 HAUT 2014 Tutorial Solns 3

 EPS = ($4,000,000 - $1,700,000)(0.6)/2,000,000 = $0.69

For alternative #2 (the stock):

EPS = ($4,000,000 - $ 500,000)(0.6)/2,200,000 = $0.95

Alternative #2 yields the highest projected EPS for the next period because
increased cost of debt is not offset by the increased advantage of leverage in
this case.

7. The Grey Gauge Company currently has 500,000 shares of common stock
outstanding in addition to $5 million in 8% bonds. The company is
considering a $5 million expansion program which can be financed with
(1) all common stock at $20 a share, or
(2) all bonds at 10% interest.
If the most likely EBIT for the firm will be $2.5 million, compute the EBIT-
EPS indifference point and use it to determine which financing method would
be preferred. Assume a 50% tax rate.
Answer:
To calculate the indifference point, we must equate the earnings per share and
solve for the unknown EBIT.

EPS of Alternative #1 = EPS of Alternative 2 (Solving for EBIT)

(EBIT - $900,000)(0.5)/500,000 = (EBIT - $400,000)(0.5)/750,000
1.5(EBIT - $900,000) = (EBIT - $400,000)
EBIT = $1,900,000

The resulting EBIT is $1,900,000 and represents the indifference point.

Since the expected EBIT of $2,500,000 exceeds our indifference point of
$1,900,000, then debt is the best alternative (#2).

8. Eagle Corporation makes buses. During the past year, it earned $1 million
after taxes. It has a 50% tax rate, no debt or preferred stock, and 250,000
shares of common stock outstanding. At the beginning of the year, the
company will raise $1 million in debt at an interest rate of 10%. To what level
would EBIT have to change in order for EPS to be the same as before the debt
financing? What percentage of a change to EBIT does this represent?
Answer:
The "old" EPS = $1,000,000/250,000 = $4.
<<Now quote the "new" EPS to $4 given the issuance of debt.>>

Solving for the "new" EBIT given that EPS = $4 and interest on the new debt
is $100,000:
(EBIT - $100,000)(0.5)/250,000 = $4, thus EBIT = $2,100,000.

Calculating the "old" EBIT:

Old EBIT = $1,000,000/0.5 = $2,000,000.

The change in EBIT:

Change = ($2,100,000 - $2,000,000)/$2,000,000 = 5 percent.

ACF 103 HAUT 2014 Tutorial Solns 4

Chapter 17
1. Good Souls Hospital pays no corporate taxes. It has a net operating income of
$1 million and no debt in its capital structure. The market value of its common
stock is $10 million. Suppose the hospital decided to borrow $2 million in
long-term debt at an interest rate of 8% in order to retire some of its common
stock. Compute the market value of the hospital using the net operating
income and traditional approaches to valuation. Explain your results.
Answer:
Under the net operating income method, the $1 million in net operating
income is capitalized at 10% and has a market value of $10 million, with or
without debt.

Net operating income:

Market value of equity = $1,000,000/0.10 = $10,000,000
Market value of hospital = $10,000,000.
Under the traditional approach, the $1 million in net operating income is
capitalized at 10% to get the market value of equity and then debt is added.

Traditional Approach (with NO debt):

Net income = $1,000,000 - ($0) = $1,000,000
Capitalized market value of equity = $1,000,000/0.10 = $10,000,000
Market value of hospital = $10,000,000 + $0 = $10,000,000.

Traditional Approach (with debt):

Net income = $1,000,000 - ($2,000,000)(0.08) = $840,000
Capitalized market value of equity = $840,000/0.10 = $8,400,000
Market value of hospital = $8,400,000 + $2,000,000 = $10,400,000.

The Net Operating Income approach generates a hospital value that is

independent of the financing structure of the firm. Thus, the firm is worth $10
million. The traditional approach to valuation shows at this time the firm can
increase its value with the judicious use of debt assuming that the capitalized
cost of debt is constant.

2. Alpha and Beta are identical firms in every respect except for capital
structure. Alpha has 60% debt and 40% equity. Beta has 40% debt and 60%
equity. Capital markets are perfect, the borrowing rate for each is 12%, and
there are no taxes. If you own 1% of each company, and if each has net
operating income of $400,000, what is your dollar return for each firm if the
overall capitalization rate is 20%? What is the implied equity capitalization
rate?
Answer:
For Alpha Co.:
Value of firm = $400,000/0.20 = $2,000,000
Market value of debt = ($2,000,000)(0.60) = $1,200,000
Interest = ($1,200,000)(0.12) = $144,000
Earnings to common = $400,000 - $144,000 = $256,000
Your 1% share = ($256,000)(0.01) = $2,560
Market value of stock = ($2,000,000)(0.40) = $800,000
Equity capitalization rate = $256,000/$800,000 = 32.0%.

ACF 103 HAUT 2014 Tutorial Solns 5

 For Beta Co.:
Value of firm = $400,000/0.20 = $2,000,000
Market value of debt = ($2,000,000)(0.40) = $800,000
Interest = ($800,000)(0.12) = $96,000
Earnings to common = $400,000 - $96,000 = $304,000
Your 1% share = ($304,000)(0.01) = $3,040
Market value of stock = ($2,000,000)(0.60) = $1,200,000
Equity capitalization rate = $304,000/$1,200,000 = 25.3%.

Alpha, the more highly leveraged firm, has a larger capitalization rate (32%)
than Beta Co.

3. Hangzhou Rubber Company and Zhengzhou Tyres Inc., are identical except
for capital structures. Hangzhou has 50% debt and 50% equity financing,
whereas Zhengzhou has 20% debt and 80% equity financing. (All percentages
are in market value terms.) The borrowing rate for both companies is l3% in a
no-tax world, and capital markets are assumed to be perfect. The earnings of
both companies are not expected to grow, and all earnings are paid out to
shareholders in the form of dividends.
a. If you own 3% of the common stock of Hangzhou, what is your dollar return if
the company has net operating income of $360,000 and the overall
capitalization rate of the company, ko, is 18%? What is the implied equity
capitalization rate, ke?
b. Zhengzhou has the same net operating income as Hangzhou. What is the
implied equity capitalization rate of Zhengzhou? Why does it differ from that
of Hangzhou?

Answer:
a. Hangzhou Rubber Company:
O Net operating income $ 360,000
ko Overall capitalization rate ÷ 0.18
V Total value of the firm (B + S) $2,000,000
B Market value of debt (50%) 1,000,000
S Market value of stock (50%) $1,000,000
O Net operating income $ 360,000
I Interest on debt (13%) 130,000
E Earnings available to common shareholders (O – I) $ 230,000
3% of $230,000 = $6,900
Implied equity capitalization rate, ke = E/S = $230,000/$1,000,000 = 23%

b. Zhengzhou Tyres, Inc.:

O Net operating income $ 360,000
ko Overall capitalization rate ÷ 0.18
V Total value of the firm (B + S) $2,000,000
B Market value of debt (20%) 400,000
S Market value of stock (80%) $1,600,000
O Net operating income $ 360,000
I Interest on debt (13%) 52,000
E Earnings available to common shareholders (O – I) $ 308,000

ACF 103 HAUT 2014 Tutorial Solns 6

Implied equity capitalization rate, ke = E/S = $308,000/$1,600,000 = 19.25%

Zhengzhou has a lower equity capitalization rate than Hangzhou, because

Zhengzhou uses less debt in its capital structure. As the equity capitalization
rate is a linear function of the debt-to equity ratio when we use the net
operating income approach, the decline in equity capitalization rate exactly
offsets the disadvantage of not employing so much in the way of “cheaper”
debt funds.

4. Text book Ch 17, problem # 3 (p.470)

Note: For part (b), prepare a table (in two parts) with the data in it – do not
draw the graph. The column headings should be:
Part 1 # shares B EBIT I EBT EAT
Part 2 ki EPS P ke = EPS/P S = (# shares) × P V = B + S

Answer:
a. $400,000 in debt. The market price per share of common stock is highest at
this amount of financial leverage.

b. (000s omitted)
# shares B EBIT I EBT EAT
100 $0 $250 $ 0.0 $250.0 $125.00
90 100 250 10.0 240.0 120.00
80 200 250 20.0 230.0 115.00
70 300 250 31.5 218.5 109.25
60 400 250 44.0 206.0 103.00
50 500 250 60.0 190.0 95.00
40 600 250 84.0 166.0 83.00

ki EPS P ke = EPS/P S = (# shares) × P V=B+S

--- $1.25 $10.00 12.5% $1,000.0 $1000.0
5.00% 1.33 10.00 13.3 900.0 1000.0
5.00 1.44 10.50 13.7 840.0 1040.0
5.25 1.56 10.75 14.5 752.5 1052.5
5.50 1.72 11.00 15.6 660.0 1060.0
6.00 1.90 10.50 18.1 525.0 1025.0
7.00 2.08 9.50 21.8 380.0 980.0

ki(B/V) + ke(S/V) = ko
(12.5%)($1,000/$1,000.0) = 12.50%
(5.00%)($100/$1,000.0) + (13.3%)($900.0/$1,000.0) = 12.47
(5.00%)($200/$1,040.0) + (13.7%)($840.0/$1,040.0) = 12.03
(5.25%)($300/$1,052.5) + (14.5%)($752.5/$1,052.5) = 11.86
(5.50%)($400/$1,060.0) + (15.6%)($660.0/$1,060.0) = 11.79
(6.00%)($500/$1,025.0) + (18.1%)($525.0/$1,025.0) = 12.20
(7.00%)($600/$980.0) + (21.8%)($380/$980.0) =
12.74

ACF 103 HAUT 2014 Tutorial Solns 7

c. Yes. The optimal capital structure – the one possessing the lowest overall cost
of capital – involves $400,000 in debt.

5. Text book Ch 17, problem # 4 (p.470)

Answer:
a.
All-equity Debt and Equity
EBIT $1,000,000 $1,000,000
Interest to debt holders 0 450,000
EBT $1,000,000 $ 550,000
Taxes (40%) 400,000 220,000
Incomes available to common shareholders $ 600,000 $ 330,000
Income to debt holders plus income
available to shareholders $ 600,000 $ 780,000

b. Present value of tax-shield benefits = (B)(t c) = ($3,000,000)(0.40) = $1,200,000

c. Value of all-equity financed firm = EAT/k e = $600,000/(0.20) = $3,000,000

Value of recapitalized firm = $3,000,000 + $1,200,000 = $4,200,000

6. Li Na Corporation has earnings before interest and taxes of $6 million and a

40% tax rate. It is able to borrow at an interest rate of 14%, whereas its equity
capitalization rate in the absence of borrowing is 18%. The earnings of the
company are not expected to grow, and all earnings are paid out to
shareholders in the form of dividends. In the presence of corporate but no
personal taxes, what is the value of the company in an M&M world with no
financial leverage? With $8 million in debt? With $14 million in debt?

Answer:
Value of firm if unlevered:
Earnings before interest and taxes $ 6,000,000
Interest 0
Earnings before taxes $ 6,000,000
Taxes (40%) 2,400,000
Earnings after taxes $ 3,600,000
Equity capitalization rate, ke ÷ 0.18
Value of the firm (unlevered) $20,000,000

Value with $4 million in debt:

Value of levered firm = Value of firm if unlevered + PV of tax-shield benefits of debt
= $20,000,000 + ($8,000,000) (0.40)
= $23,200,000
Value with $7 million in debt:
= $20,000,000 + ($14,000,000)(0.40)
= $25,600,000

Due to the tax subsidy, the firm is able to increase its value in a linear manner
with more debt.

7. A firm with no debt has a current market value of $100 million. It borrows $10
million at 8%. Management estimates the present value of associated

ACF 103 HAUT 2014 Tutorial Solns 8

 bankruptcy and agency costs at $2 million. If the company's tax rate is 35%,
what is its new market value?

Answer::
Market value = $100,000,000 - $2,000,000 + ($10,000,000)(0.08)(0.35)/0.08
= $101,500,000

The new market value increases because of a $3.5 million tax-shield benefit,
but is then reduced by a $2 million increase in bankruptcy and agency costs.

ACF 103 HAUT 2014 Tutorial Solns 9