Calculate Optimal Capital Structure

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					Question 9
EBIT – EPS and capital structure. Data-Check is considering two capital structures.
The key information is shown in the following table. Assume a 40 percent tax rate.




   Source of            Structure A                       Structure B
   capital
   Long-term debt       R100 000 at 16% coupon            R200 000 at 17% coupon
                        rate                              rate
   Common stock         4 000 shares                      2 000 shares




a.Calculate two EBIT-EPS coordinates for each of the structures by selecting any two
EBIT values and finding their associated EPS.
b.Plot the two capital structures on a set of EBIT-EPS axes.
c.Indicate over what EBIT range, if any, each structure is preferred.
d.Discuss the leverage and risk aspects of each structure.
e.If the firm is fairly certain that its EBIT will exceed R75 000, which structure would you
recommend? Why?
       Question 9:
  CAPITAL STRUCTURE – LEVERAGE:
STRUCTURE A             STRUCTURE B

EBIT     ………     ………    ………     ………
- Int    ………     ………    ………     ………
EAIBT    ………     ……….   ………     ………
- Tax    ………     ………    ………..   ………
EAIT     ………     ………    ……….    ……….
EPS      ………     ………    ……….    ……….
         ………     ……….   ……….    ……….
   =     ………     ……….   ……….    ………..
[(EBIT – I) X (1 – T)] – PD = [(EBIT – I) X (1 – T)] – PD
             n                               n

[(EBIT –_____) X _____)] – _____ = [(EBIT – ____) X____] – _____
        ………………..                               ………………

     ____+EBIT – _____ – _____ =             ____EBIT – ____ –______
            ………………                                ………………


          ______EBIT – _____             =      _____EBIT – _______
              ……………..                                …………….

_________ EBIT – ________________= _______EBIT – ________

                 _________EBIT = ______________

                       EBIT = R______________
  WHAT DOES THIS
     MEAN?
• IF THE COMPANY’S EBIT IS
  LESS THAN R52 000, THEN THE
  CAPITAL STRUCTURE TO
  CHOOSE IS STRUCTURE A.
• WHY? BECAUSE STRUCTURE A
  HAS THE HIGHEST EPS AT AN
  EBIT BELOW R52 000.
• IF THE COMPANY’S EBIT IS
  GREATER THAN R52 000, THEN
  THE CAPITAL STRUCTURE TO
  CHOOSE IS STRUCTURE B.
• WHY? BECAUSE STRUCTURE B
  HAS THE HIGHEST EPS AT AN
  EBIT ABOVE R52 000.
  AND WHAT OFTEN
   HAPPENS AS A
     RESULT?
• THE INEXPERIENCED FINANCIAL MANAGER
  WILL THEN CHOOSE STRUCTURE B AS
  LONG AS THE COMPANY’S EBIT IS GREATER
  THAN R52 000.
• HOWEVER, THIS MAY BE SHORTSIGHTED.
  STRUCTURE B HAS MORE DEBT (DOUBLE
  THAT OF STRUCTURE A). IN ADDITION,
  STRUCTURE B ALSO DEMANDS A HIGHER
  INTEREST RATE AND THEREFORE A
  GREATER AMOUNT OF INTEREST TO BE
  PAID (R34 000 VERSUS R16 000).
• SO, STRUCTURE B IS A FAR MORE RISKY
  STRUCTURE AND MUST THEREFORE BE
  USED WITH CAUTION.
   THE ILLUSION OF
       WEALTH
• BY USING STRUCTURE B, THE COMPANY IS
  IN ESSENCE “BUYING EARNINGS”.
  STRUCTURE B ENABLES THE COMPANY TO
  SHOW A MUCH HIGHER EPS AS LONG AS
  THE COMPANY’S EBIT IS GREATER THAN
  R52 000.
• HOW HAS THIS HAPPENED?
• INTEREST PAID ON DEBT IS TAX
  DEDUCTIBLE. AS A RESULT, THE COMPANY
  IS ABLE TO REDUCE ITS TAX BURDEN
  BECAUSE THE INTEREST THAT IT PAYS
  REDUCES ITS TAXABLE INCOME.
• THIS IS KNOWN AS THE “TAX SHIELD”
  ACCORDING TO MODIGLIANI AND MILLER
  (MM).
Question 10
EBIT-EPS and preferred stock. Litho-Print is considering two possible capital structures,
A and B, shown in the following table. Assume a 40 percent tax rate.




         Source of capital   Structure A                Structure B
         Long-term debt      R75 000 at 16% coupon      R50 000 at 15% coupon
                             rate                       rate
         Preferred stock     R10 000 with an 18%        R15 000 with an 18%
                             annual dividend            annual dividend
         Common stock        8 000 shares               10 000 shares




  a.Calculate two EBIT-EPS coordinates for each of the structures by selecting any
  two EBIT values and finding their associated EPS.
  b.Graph the two capital structures on the same set of EBIT-EPS axes.
  c.Discuss the leverage and risk associated with each of the structures.
  d.Over what range of EBIT is each structure preferred?
  e.Which structure do you recommend if the firm expects its EBIT to be R35,000?
  Explain
Question 10
CAPITAL STRUCTURE AND LEVERAGE



          STRUCTURE A        STRUCTURE B
EBIT      ______   ______    ______   _______
-   INT   ______   ______    ______   _______
EAIBT    ______    _______   _______ ________
- TAX ______       _______   _______ _______
EARNINGS ______    _______   _______ _______
- PD      _____    ______    _______ ______
EAIT     ______    _______   ________ _______

EPS       ______ _______     _______ _______
          ………. …………          ………. …………
          = R____ R______    = R____ R______
  Question 10 Contd:

CAPITAL STRUCTURE – LEVERAGE:



                                          A
   EPS                                        B
 _____

 _____


 _____

 _____

         0         ________   ________
                                         EBIT
             X=?
[(EBIT – I) X (1 – T)] – PD = [(EBIT – I) X (1 – T)] – PD
            n                               n

[(EBIT –……….) X …)] = [(EBIT – ………..) X …….]
        ………….                …………..

     ……………                 =    ……………………
      …………                        …………..

…………. – …………..             = …………. – ……………

            …..………..       = ……………..

                     EBIT = ………………
Question 11
Integrative – Optimal capital structure. Nelson Corporation has made the following
forecast of sales, with the associated probability of occurrence noted.

           Sales               Probability
         R200,00                         .20
         300,000                         .60
         400,000                         .20

  The company has fixed operating costs of R100 000 per year, and variable
  operating costs represent 40 percent of sales. The existing capital structure
  consists of 25 000 shares of common stock that have a R10 per share book
  value. No other capital items are outstanding. The marketplace has assigned the
  following discount rates to risky earnings per share.

             Coefficient of        Estimated required
            variation of EPS          return, ks(%)
                   .43                       15%
                   .47                        16
                   .51                        17
                   .56                        18
                   .60                        22
                   .64                        24
  The company is contemplating shifting its capital structure by substituting debt in the
  capital structure for common stock. The three different debt ratios under consideration
  are shown in the following table, along with an estimate of the corresponding required
  interest rate on all debt.
                                    Interest rate
                   Debt ratio             on
                                       all debt
                    20%                  10%
                     40                      12
                     60                      14

   The tax rate is 40 percent. The market value of the equity for a levered firm can be
   found by using the simplified method.
   a.Calculate the expected earnings per share (EPS), the standard deviation of EPS,
   and the coefficient of variation of EPS for the three proposed capital structures.
   b.Determine the optimal capital structure, assuming (1) maximisation of earnings per
   share and (2) maximisation of share value.
   c.Construct a graph showing the relationships in b.
 Question 11:
                DEBT     EQUITY


        A


        B


        C


        D

STRUCTURE B:
                ………..    ……….     …………
Sales           ……….     ………..    ………...
- FC            ……….     ………..    …………
- VC             ……..    ………..    …………
EBIT             ……...    ………     …………
- Int             …….      ……..    ……...
EAIBT            ………      ………     …………
- Tax             …….     ………     ……….
EAIT              …….     ………     ……….
EPS         =     …….     ………     ……….
                 ……...    ………     ……….
            =   ……….     ………..    …………

EPS = (………..x……..) + (………x……) + (……..x………)
    = …………….
            n
x    =      (xi – x)² x Pri
            i=1




            n

x    =      (EPSi – EPS)² x Pri
            i=1




      =    [(…………)² x ……]
          +[(…………)² x ……]
          +[(…………)² x ……]

      =   R1,14

CVx   =    x
           x

CVEPS =    EPS
           EPS
      =   ………

      =   ………
P0    =   EPS
           k
      =   ………

      =   ………
    EPS      CV   k   P0
A
B
C
D
   WHAT DOES THE
   GRAPH TELL US?
• IF YOU WANTED TO MAXIMISE EARNINGS,
  THEN YOU WILL CHOOSE STRUCTURE D.
• WHY? BECAUSE IT HAS THE HIGHEST EPS.
• IF YOU WANTED TO MAXIMISE SHARE
  PRICE, THEN YOU WILL CHOOSE
  STRUCTURE C.
• WHY? BECAUSE IT HAS THE HIGHEST
  SHARE PRICE.
• SO, WHICH IS THE BETTER STRUCTURE TO
  CHOOSE???
• TO ANSWER THIS QUESTION, WE MUST ASK
  OURSELVES WHAT THE GOAL OF THE
  FINANCIAL MANAGER IS?
• ANSWER = TO MAXIMISE THE WEALTH OF
  THE SHAREHOLDERS.
    SHAREHOLDERS
       WEALTH
     MAXIMISATION
• HOW DO WE MAXIMISE SHAREHOLDERS
  WEALTH?
• IS IT THROUGH MAXIMISING EARNINGS OR
  MAXIMISING THE SHARE PRICE???
• SHAREHOLDERS WEALTH IS MAXIMISED
  THROUGH …
• SHARE PRICE.
• THEREFORE, THE COMPANY SHOULD
  CHOOSE STRUCTURE C.
 HOW COME THE GRAPH
 HAS THE SHAPE IT DOES
       (CURVES)?
• WHAT YOU HAVE SEEN IS THAT THE
  COMPANY WAS ABLE TO GENERATE
  HIGHER EPS BY MANIPULATING THE
  CAPITAL STRUCTURE ONLY!
• THE COMPANY DID NOT MAKE MORE SALES.
  IT DID NOT LOWER COSTS. ALL IT DID WAS
  CHANGE (MANIPULATE) THE DEBT:EQUITY
  RATIO.
• IN ESSENCE, THEY HAVE USED THE TAX
  SHIELD ON INTEREST TO ACHIEVE THIS
  INCREASE IN EPS.
     CAPITAL
STRUCTURE THEORY
      (MM)
•   ACCORDING TO MM, A COMPANY’S OPTIMAL
    CAPITAL STRUCTURE IS 100% DEBT, NO EQUITY.
•   WHY?
•   BECAUSE, INTEREST IS TAX DEDUCTIBLE (TAX
    SHIELD). DIVIDENDS ARE NOT TAX DEDUCTIBLE
    – THEY ARE PAID AFTER TAX HAS BEEN PAID.
•   IN ADDITION, EQUITY (ORDINARY SHARES) IS THE
    MOST EXPENSIVE SOURCE OF CAPITAL (REFER
    BACK TO WACC).
•   THEREFORE, ACCORDING TO MM, THE OPTIMAL
    CAPITAL STRUCTURE IS 100% DEBT.
•   IS THIS ALWAYS PRACTICAL?
•   THE MORE DEBT THAT A COMPANY HAS, THE
    CLOSER IT IS TO BANKRUPTCY (FINANCIAL
    DISTRESS). THERE ARE ONLY CERTAIN TYPES
    OF COMPANIES/INDUSTRIES THAT WE WOULD BE
    WILLING TO ACCEPT HIGHER DEBT RATIOS.
•   THESE ARE COMPANIES THAT HAVE A VERY
    HEAVY FIXED ASSET BASE, EG, PROPERTY,
    MINING.
     CAPITAL
STRUCTURE THEORY
      (MM)
• LET US ASSUME THAT WE HAVE A
  COMPANY THAT HAS 100% EQUITY AND
  WOULD LIKE TO TAKE ON DEBT.
• WE KNOW THAT DEBT IS CHEAPER THAN
  EQUITY. THEREFORE WHAT DO YOU
  EXPECT WILL HAPPEN TO THE COMPANY’S
  WACC AS THEY TAKE ON DEBT AND
  SUBSTITUTE IT FOR EQUITY?
• THE WACC WILL DECLINE.
• THEREFORE, ACCORDING TO MM, THE
  OPTIMAL CAPITAL STRUCTURE IS 100%
  DEBT.
• BUT, AS THE COMPANY TAKES ON
  INCREASING AMOUNTS OF DEBT, THE RISK
  FOR THE LENDER INCREASES. AS A
  RESULT, THE COST OF DEBT (Kd) WILL
  REACH A POINT WHERE IT WILL START TO
  INCREASE AGAIN.
    OPTIMAL CAPITAL
      STRUCTURE
•   ANY COMPANY SHOULD TRY TO DETERMINE THE
    POINT AT WHICH ITS WACC IS AT A MINIMUM.
•   APART FROM THE FACT THAT THE LOWER THE
    WACC, THE LESS MONEY IT COSTS THE FIRM TO
    MAINTAIN THAT CAPITAL, THE COMPANY WILL
    THEN HAVE THE LOWEST DISCOUNT RATE THAT
    IT CAN ACHIEVE.
•   WE KNOW THAT THE DISCOUNT RATE IS THE
    RATE THAT IS USED TO CALCULATE PROJECT
    NPVs. THEREFORE, THE LOWER THE DISCOUNT
    RATE, THE MORE LIKELY A PROJECT IS TO BE
    ACCEPTABLE (THE SMALLER THE DISCOUNT
    RATE, THE HIGHER THE NPV).
•   THE MORE PROJECTS THAT THE FIRM CAN
    INVEST IN, THE MORE VALUE THAT WILL BE
    ADDED TO THE FIRM.
   OPTIMAL CAPITAL
     STRUCTURE
• THE MORE VALUE THAT IT IS ADDED TO THE
  FIRM, THE GREATER THE WEALTH OF
  SHAREHOLDERS.
• THE GREATER THE WEALTH OF THE
  SHAREHOLDERS, THE HIGHER THE SHARE
  PRICE.
• THEREFORE, THE FIRM’S OPTIMAL CAPITAL
  STRUCTURE WILL BE THE POINT AT WHICH:
   – THE WACC IS AT A MINIMUM,
   – WHICH WILL CORRESPOND TO THE POINT
     WHERE THE SHARE PRICE IS AT A MAXIMUM.
   THE COMPANY’S
     DECISIONS
• THE COMPANY MUST FIRSTLY
  DECIDE UPON ITS CAPITAL
  STRUCTURE.
• THE CAPITAL STRUCTURE
  THAT THE COMPANY USES
  WILL DETERMINE THE
  COMPANY’S WACC.
• THE WACC IS THE DISCOUNT
  RATE THAT THE COMPANY
  USES TO CALCULATE THE NPV
  OF NEW PROJECTS THAT IT IS
  PLANNING ON INVESTING IN.
     DIVIDEND POLICY


1) Relevance:
    -Relevant
    -Gordon + Lintner – “Bird in the hand”

                   Main Co
                                                 Granny


                     Trust                   
          A Co       B Co       C Co




2) Irrelevance:
     - M+M
     -Co to invest in +ve NPV projects.
     -Any balance to be paid out as a dividend( residual)
RE = ………..        Debt =…………
Project =………      Equity =……….

Under residual theory:


       Project =…………..


Debt                     Equity
…….                      ……..
…….                      …….

                ……..         ……..
                RE           New
                             Shares

				
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