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E13-1.
Breakeven analysis
Answer: The operating breakeven point is the level of sales at which all fixed and variable operating
costs are covered and EBIT is equal to $0.
Q FC (P VC)
Q $12,500 ($25 $10) 833.33, or 834 units
E13-2.
Answer: Calculate the breakeven point for the current process and the breakeven point for the new
process, and compare the two.
Current breakeven: Q1 $15,000 ($6.00 $2.50) 4,286 boxes
Q2 $16,500 ($6.50 $2.50) 4,125 boxes
New breakeven:
If Great Fish Taco Corporation makes the investment, it can lower its breakeven point by
161 boxes.
E13-3.
E13-4.
1.33
15,000 ($20 $12) $30,000 $90,000
DFL
Answer: Substitute EBIT $20,000, I $3,000, PD $4,000, and the tax rate (T 0.38) into
Equation 12.7.
$20,000
$20,000 $3,000 [$4,000 (1 (1 0.38)]
$20,000
1.90
$10,548
E13-5.
Answer: Calculate EBIT, then NOPAT and the weighted average cost of capital (WACC) for Cobalt
Industries.
EBIT (150,000 $10) $250,000 (150,000 $5) $500,000
NOPAT EBIT (1 T) $500,000 (1 0.38) $310,000
Value of the firm
NOPAT $310,000
$3,647,059
ra
0.085
Solutions to Problems
FC
( P VC )
$12,350
Q
1,300
($24.95 $15.45)
Q
FC
( P VC )
Firm F:
$45,000
4,000 units
$18.00 $6.75
Firm G:
$30,000
4,000 units
$21.00 $13.50
Firm H:
$90,000
5,000 units
$30.00 $12.00
b. From least risky to most risky: F and G are of equal risk, then H. It is important to recognize
that operating leverage is only one measure of risk.
P13-3. Breakeven pointalgebraic and graphical
LG 1; Intermediate
a. Q FC (P VC)
Q $473,000 ($129 $86)
Q 11,000 units
b.
a.
$73,500
21,000 CDs
$13.98 $10.48
2,000 figurines
a. Q
( P VC ) $8.00 $6.00
b. Sales
Less:
Fixed costs
Variable costs ($6 1,500)
EBIT
4,000
9,000
$3,000
c.
$15,000
Sales
Less:
Fixed costs
Variable costs ($6 1,500)
EBIT
d.
$10,000
4,000
9,000
$2,000
4,000 units
P VC
$8 $6
$2
e. One alternative is to price the units differently based on the variable cost of the unit. Those
more costly to produce will have higher prices than the less expensive production models. If
they wish to maintain the same price for all units they may need to reduce the selection from
the 15 types currently available to a smaller number that includes only those that have an
average variable cost below $5.33 ($8 $4,000/1,500 units).
P13-8. EBIT sensitivity
LG 2; Intermediate
a. and b.
8,000 Units
Sales
Less: Variable costs
Less: Fixed costs
EBIT
$72,000
40,000
20,000
$12,000
10,000 Units
$90,000
50,000
20,000
$20,000
12,000 Units
$108,000
60,000
20,000
$ 28,000
c.
Unit Sales
Percentage
Change in
unit sales
Percentage
Change in
EBIT
8,000
10,000
12,000
40%
d. EBIT is more sensitive to changing sales levels; it increases/decreases twice as much as sales.
P13-9. DOL
LG 2; Intermediate
FC
$380,000
8,000 units
a. Q
( P VC ) $63.50 $16.00
9,000 Units
10,000 Units
11,000 Units
Sales
Less: Variable costs
Less: Fixed costs
EBIT
$571,500
144,000
380,000
$ 47,500
$635,000
160,000
380,000
$ 95,000
$698,500
176,000
380,000
$142,500
1,000
1,000 10,000
10%
$47,500
$47,500 95,000 = 50%
b.
c.
Change in EBIT
% Change in EBIT
0
0
1,000
1,000 10,000 10%
0
0
$47,500
$47,500 95,000 =
50%
d.
% change in EBIT
% change in sales
e.
50 10 5
DOL
[Q ( P VC )]
[Q ( P VC )] FC
DOL
DOL
$475,000
5.00
$95,000
P13-10. DOLgraphic
LG 2; Intermediate
FC
$72,000
24,000 units
a. Q
( P VC ) $9.75 $6.75
DOL
[Q ( P VC )]
[Q ( P VC )] FC
DOL
DOL
DOL
d.
DOL
e.
b.
c.
50 10 5
EBIT
Less: Interest
Net profits before taxes
Less: Taxes
Net profit after taxes
Less: Preferred dividends
Earnings available to
common shareholders
EPS (4,000 shares)
(a)
(b)
(c)
$24,600
9,600
$15,000
6,000
$ 9,000
7,500
$ 1,500
$30,600
9,600
$21,000
8,400
$12,600
7,500
$ 5,100
$35,000
9,600
$25,400
10,160
$15,240
7,500
$ 7,740
$ 0.375
$ 1.275
$ 1.935
DFL
DFL
$80,000
40,000
$40,000
16,000
$24,000
$ 12.00
$120,000
40,000
$ 80,000
32,000
$ 48,000
$ 24.00
EBIT
EBIT I PD
(1 T )
$80,000
2
[$80,000 $40,000 0]
c.
EBIT
Less: Interest
Net profits before taxes
Less: Taxes (40%)
Net profit after taxes
EPS (3,000 shares)
DFL
$80,000
1.25
[$80,000 $16,000 0]
$80,000
16,000
$64,000
25,600
$38,400
$ 12.80
$120,000
16,000
$104,000
41,600
$ 62,400
$ 20.80
$3,000
$1,000
$2,000
$3,300
$1,000
$2,300
10.0%
0.0%
15.0%
15% 10% 1.50
$3,000
$1,350
$1,650
Percentage
Change
Percentage
Change
$3,300
10.0%
$1,350
0.0%
$1,950
18.2%
18.2% 10% 1.82
b. Based on his calculations, the amount that Max will have available after loan payments with
his current debt changes by 1.5% for every 1% change in the amount he will have available
for making the loan payment. This is less responsive and therefore less risky than the 1.82%
change in the amount available after making loan payments with the proposed $350 in monthly
debt payments. Although it appears that Max can afford the additional loan payments, he
must decide if, given the variability of Maxs income, he would feel comfortable with the
increased financial leverage and risk.
P13-14. DFL and graphic display of financing plans
LG 2, 5; Challenge
a.
DFL
DFL
b.
EBIT
EBIT I PD
(1 T )
$67,500
1.5
[$67,500 $22,500 0]
c.
DFL
$67,500
$6,000
1.93
d. See graph, which is based on the following equation and data points.
Financing
EBIT
Original
financing
plan
$67,500
$17,500
$67,500
$17,500
Revised
financing
plan
EPS
e. The lines representing the two financing plans are parallel since the number of shares of
common stock outstanding is the same in each case. The financing plan, including the
preferred stock, results in a higher financial breakeven point and a lower EPS at any
EBIT level.
P13-15. Integrativemultiple leverage measures
LG 1, 2; Intermediate
$28,000
a. Operating breakeven
175,000 units
$0.16
b.
DOL
[Q ( P VC )]
[Q ( P VC )] FC
DOL
1.78
[400,000 ($1.00 $0.84)] $28,000 $36,000
c. EBIT (P Q) FC (Q VC)
EBIT ($1.00 400,000) $28,000 (400,000 $0.84)
EBIT $400,000 $28,000 $336,000
EBIT $36,000
EBIT
DFL
EBIT I PD
(1 T )
DFL
$36,000
$2,000
$36,000 $6,000
(1 0.4)
1.35
[Q ( P VC )]
DTL
d.
DTL
DTL
PD
Q ( P VC ) FC I
(1 T )
$2,000
400,000 ($1.00 $0.84) $28,000 $6,000
(1 0.4)
$64,000
$64,000
2.40
[$64,000 $28,000 $9,333] $26,667
1.25
a. DOL R
[100,000 ($2.00 $1.70)] $6,000 $24,000
DFL R
$24,000
1.71
[$24,000 $10,000]
DOLW
1.71
[100,000 ($2.50 $1.00)] $62,500 $87,500
DFLW
$87,500
1.25
[$87,500 $17,500]
DOL
d.
DFL
DFL
3.0
[30,000 ($6.00 $3.50)] $50,000 $25,000
EBIT
EBIT I PD
(1 T )
$25,000
$25,000
75.00
$25,000 $13,000 [$7,000 (1 0.6)] $333.33
Change in sales
15,000
50%
30,000
Debt
Equity
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
$900,000
$900,000
$800,000
$700,000
$600,000
$500,000
$400,000
$100,000
Theoretically, the debt ratio cannot exceed 100%. Practically, few creditors would extend loans to
companies with exceedingly high debt ratios (70%).
0.20
0.60
0.20
$200,000
140,000
75,000
$(15,000)
12,000
$(27,000)
(10,800)
$(16,200)
$300,000
210,000
75,000
$ 15,000
12,000
$ 3,000
1,200
$ 1,800
$400,000
280,000
75,000
$ 45,000
12,000
$ 33,000
13,200
$ 19,800
$(16,200)
10,000
$ (1.62)
$ 1,800
10,000
$ 0.18
$ 19,800
10,000
$ 1.98
b. EPS
Earnings after taxes
Number of shares
EPS
n
EPS
(EPS EPS)
i 1
Pri
EPS [($1.62 $0.18)2 0.20] [($0.18 $0.18)2 0.60] [($1.98 $0.18)2 0.20]
EPS
Expected EPS
1.138
6.32
0.18
c.
EBIT *
$(15,000)
$15,000
$45,000
Less: Interest
Net profit before taxes
Less: Taxes
Net profits after taxes
EPS (15,000 shares)
0
$(15,000)
(6,000)
$ (9,000)
$ (0.60)
0
$15,000
6,000
$ 9,000
$ 0.60
0
$45,000
18,000
$27,000
$ 1.80
From part a
EPS [( $0.60 $0.60)2 0.20] [($0.60 $0.60)2 0.60] [($1.80 $0.60)2 0.20]
With Debt
All Equity
$0.180
$1.138
6.320
$0.600
$0.759
1.265
Expected EPS
EPS
CVEPS
Including debt in Tower Interiors capital structure results in a lower expected EPS, a higher
standard deviation, and a much higher coefficient of variation than the all-equity structure.
Eliminating debt from the firms capital structure greatly reduces financial risk, which is
measured by the coefficient of variation.
P13-21. EPS and optimal debt ratio
LG 4; Intermediate
a.
Maximum EPS appears to be at 60% debt ratio, with $3.95 per share earnings.
EPS
b. CVEPS
EPS
Debt Ratio
CV
0%
20
40
60
80
0.5
0.6
0.8
1.0
1.5
$50,000
16,000
$34,000
13,600
$20,400
$ 5.10
$60,000
16,000
$44,000
17,600
$26,400
$ 6.60
Structure B
$50,000
34,000
$16,000
6,400
$ 9,600
$60,000
34,000
$26,000
10,400
$15,600
$ 7.80
4.80
Structure B
$16,000
$34,000
b.
c.
d. Structure A has less risk and promises lower returns as EBIT increases. B is more risky since
it has a higher financial breakeven point. The steeper slope of the line for Structure B also
indicates greater financial leverage.
e. If EBIT is greater than $75,000, Structure B is recommended since changes in EPS are much
greater for given values of EBIT.
P13-23. EBIT-EPS and preferred stock
LG 5: Intermediate
a.
Structure A
EBIT
Less: Interest
Net profits before taxes
Less: Taxes
Net profit after taxes
Less: Preferred dividends
Earnings available for
common shareholders
EPS (8,000 shares)
EPS (10,000 shares)
Structure B
$30,000
12,000
$18,000
7,200
$10,800
1,800
$50,000
12,000
$38,000
15,200
$22,800
1,800
$30,000
7,500
$22,500
9,000
$13,500
2,700
$50,000
7,500
$42,500
17,000
$25,500
2,700
$ 9,000
$ 1.125
$21,000
$ 2.625
$10,800
$22,800
$ 1.08
$ 2.28
b.
15%
30%
45%
60%
$2,000,000
0
$2,000,000
800,000
$1,200,000
$2,000,000
120,000
$1,880,000
752,000
$1,128,000
$2,000,000
270,000
1,730,000
692,000
$1,038,000
$2,000,000
540,000
$1,460,000
584,000
$ 876,000
$2,000,000
900,000
$1,100,000
440,000
$ 660,000
200,000
200,000
200,000
200,000
200,000
$1,000,000
200,000
$
5.00
$ 928,000
170,000
$
5.46
$ 838,000
140,000
$
5.99
$ 676,000
110,000
$
6.15
$ 460,000
80,000
$
5.75
EPS
rs
Debt: 0%
$5.00
P0
$41.67
0.12
Debt: 15%
$5.46
P0
$42.00
0.13
Debt: 30%
$5.99
P0
$42.79
0.14
Debt: 45%
$6.15
P0
$38.44
0.16
P0
Debt: 60%
$5.75
P0
$28.75
0.20
c. The optimal capital structure would be 30% debt and 70% equity because this is the
debt/equity mix that maximizes the price of the common stock.
P13-25. IntegrativeOptimal capital structures
LG 3, 4, 6; Challenge
a. 0% debt ratio
0.20
Sales
Less: Variable costs (40%)
Less: Fixed costs
EBIT
Less: Interest
Earnings before taxes
Less: Taxes
Earnings after taxes
EPS (25,000 shares)
$200,000
80,000
100,000
$ 20,000
0
$ 20,000
8,000
$ 12,000
$ 0.48
Probability
0.60
$300,000
120,000
100,000
$ 80,000
0
$ 80,000
32,000
$ 48,000
$ 1.92
0.20
$400,000
160,000
100,000
$140,000
0
$140,000
56,000
$ 84,000
$ 3.36
$20,000
5,000
$15,000
6,000
$ 9,000
$ 0.45
0.60
0.20
$80,000
5,000
$75,000
30,000
$45,000
$ 2.25
$140,000
5,000
$135,000
54,000
$ 81,000
$ 4.05
$20,000
12,000
$ 8,000
3,200
$ 4,800
$ 0.32
0.60
$80,000
12,000
$68,000
27,200
$40,800
$ 2.72
0.20
$140,000
12,000
$128,000
51,200
$ 76,800
$ 5.12
Debt
$20,000
21,000
$ (1,000)
(400)
$ (600)
$ (0.06)
CV
Number
of
Common
0.60
0.20
$80,000
21,000
$59,000
23,600
$35,400
$ 3.54
$140,000
21,000
$119,000
47,600
$ 71,400
$ 7.14
Dollar
Amount
Ratio
E(EPS)
EPS)
(EPS)
Shares
of Debt
Share Price*
0%
20%
40%
60%
$1.92
$2.25
$2.72
$3.54
0.9107
1.1384
1.5179
2.2768
0.4743
0.5060
0.5581
0.6432
25,000
20,000
15,000
10,000
0
$ 50,000
$100,000
$150,000
$1.92/0.16 $12.00
$2.25/0.17 $13.24
$2.72/0.18 $15.11
$3.54/0.24 $14.75
Share price: E(EPS) required return for CV for E(EPS), from table in problem.
60% debt
40% equity
Total Assets
$40,000,000
10
$ Debt
$
$ Equity
$40,000,000
1,600,000
40,000,000
4,000,000
36,000,000
1,440,000
20
40,000,000
8,000,000
32,000,000
1,280,000
30
40,000,000
12,000,000
28,000,000
1,120,000
40
40,000,000
16,000,000
24,000,000
960,000
50
40,000,000
20,000,000
20,000,000
800,000
60
40,000,000
24,000,000
16,000,000
640,000
b.
% Debt
$ Total Debt
0
10
20
30
40
50
60
0
4,000,000
8,000,000
12,000,000
16,000,000
20,000,000
24,000,000
$ Interest Expense
0.0%
7.5
8.0
9.0
11.0
12.5
15.5
0
300,000
640,000
1,080,000
1,760,000
2,500,000
3,720,000
c.
%
Debt
0
10
20
30
40
50
60
$ Interest
Expense
$
0
300,000
640,000
1,080,000
1,760,000
2,500,000
3,720,000
EBT
Taxes
@40%
Net Income
# of
Shares
EPS
$8,000,000
7,700,000
7,360,000
6,920,000
6,240,000
5,500,000
4,280,000
$3,200,000
3,080,000
2,944,000
2,768,000
2,496,000
2,200,000
1,712,000
$4,800,000
4,620,000
4,416,000
4,152,000
3,744,000
3,300,000
2,568,000
1,600,000
1,440,000
1,280,000
1,120,000
960,000
800,000
640,000
$3.00
3.21
3.45
3.71
3.90
4.13
4.01
d.
% Debt
0
10
20
30
40
50
60
EPS
$3.00
3.21
3.45
3.71
3.90
4.13
4.01
rS
P0
10.0%
10.3
10.9
11.4
12.6
14.8
17.5
$30.00
31.17
31.65
32.54
30.95
27.91
22.91
e. The optimal proportion of debt would be 30% with equity being 70%. This mix will maximize
the price per share of the firms common stock and thus maximize shareholders wealth.
Beyond the 30% level, the cost of capital increases to the point that it offsets the gain from the
lower-costing debt financing.
P13-27. Integrativeoptimal capital structure
LG 3, 4, 5, 6; Challenge
a.
Probability
0.30
Sales
Less: Variable costs (40%)
Less: Fixed costs
EBIT
$600,000
240,000
300,000
$ 60,000
0.40
0.30
$900,000
360,000
300,000
$240,000
$1,200,000
480,000
300,000
$ 420,000
b.
Debt Ratio
0%
15%
30%
45%
60%
*
Amount
of Debt
Amount
of Equity
Number of Shares of
Common Stock*
$
0
150,000
300,000
450,000
600,000
$1,000,000
850,000
700,000
550,000
400,000
40,000
34,000
28,000
22,000
16,000
Dollar amount of equity $25 per share Number of shares of common stock.
c
Debt Ratio
0%
15%
30%
45%
60%
Amount
of Debt
$
0
150,000
300,000
450,000
600,000
Before Tax
Cost of Debt
Annual Interest
0.0%
8.0
10.0
13.0
17.0
0
12,000
30,000
58,500
102,000
Calculation
($60,000 $0) (0.6) 40,000 shares
($240,000 $0) (0.6) 40,000 shares
($420,000 $0) (0.6) 40,000 shares
($60,000 $12,000) (0.6) 34,000 shares
($240,000 $12,000) (0.6) 34,000 shares
($420,000 $12,000) (0.6) 34,000 shares
($60,000 $30,000) (0.6) 28,000 shares
($240,000 $30,000) (0.6) 28,000 shares
($420,000 $30,000) (0.6) 28,000 shares
($60,000 $58,500) (0.6) 22,000 shares
($240,000 $58,500) (0.6) 22,000 shares
($420,000 $58,500) (0.6) 22,000 shares
($60,000 $102,000) (0.6) 16,000 shares
($240,000 $102,000) (0.6) 16,000 shares
($420,000 $102,000) (0.6) 16,000 shares
EPS
$0.90
3.60
6.30
$0.85
4.02
7.20
$0.64
4.50
8.36
$0.04
4.95
9.86
$1.58
5.18
11.93
Calculation
0.30 (0.90) 0.40 (3.60) 0.30 (6.30)
0.27 1.44 1.89
0.30 (0.85) 0.40 (4.02) 0.30 (7.20)
0.26 1.61 2.16
0.30 (0.64) 0.40 (4.50) 0.30 (8.36)
0.19 1.80 2.51
0.30 (0.04) 0.40 (4.95) 0.30 (9.86)
0.01 1.98 2.96
0.30 (1.58) 0.40 (5.18) 0.30 (11.93)
0.47 2.07 3.58
E(EPS)
$3.60
$4.03
$4.50
$4.95
$5.18
(2) EPS
Debt
Ratio
0%
Calculation
EPS [(0.90 3.60) 0.3] [(3.60 3.60)2 0.4] [(6.30 3.60)2 0.3]
2
EPS [(0.85 4.03)2 0.3] [(4.03 4.03)2 0.4] [(7.20 4.03)2 0.3]
EPS 3.034 0 3.034
EPS 6.068
EPS 2.463
30%
EPS [(0.64 4.50)2 0.3] [(4.50 4.50)2 0.4] [(8.36 4.50)2 0.3]
EPS 4.470 0 4.470
EPS 8.94
EPS 2.99
45%
EPS [(0.04 4.95)2 0.3] [(4.95 4.95)2 0.4] [(9.86 4.95)2 0.3]
EPS 7.232 0 7.187232
EPS 14.464
EPS 3.803
60%
EPS [(1.58 5.18)2 0.3] [(5.18 5.18)2 0.4] [(11.930 5.18)2 0.3]
(3)
Debt Ratio
0%
15%
30%
45%
60%
f.
(1)
(2)
EPS E(EPS)
CV
2.091 3.60
2.463 4.03
2.990 4.50
3.803 4.95
5.229 5.18
0.581
0.611
0.664
0.768
1.009
The return, as measured by the E(EPS), as shown in part d, continually increases as the debt
ratio increases, although at some point the rate of increase of the EPS begins to decline (the
law of diminishing returns). The risk as measured by the CV also increases as the debt ratio
increases, but at a more rapid rate.
g.
The EBIT ranges over which each capital structure is preferred are as follows:
Debt Ratio
EBIT Range
$0 $100,000
$100,001 $198,000
above $198,000
0%
30%
60%
To calculate the intersection points on the graphic representation of the EBIT-EPS approach
to capital structure, the EBIT level which equates EPS for each capital structure must be
found, using the formula in Footnote 22 of the text.
(1 T ) (EBIT I ) PD
EPS
number of common shares outstanding
EPS 0% EPS 30%
EPS 30% EPS 60%
The first calculation, EPS 0% EPS 30%, is illustrated:
[(1 0.4)(EBIT $0) 0]
EPS0%
40,000 shares
Set
EBIT=
720,000,000
$100,000
7,200
The major problem with this approach is that is does not consider maximization of
shareholder wealth (i.e., share price).
h.
Debt Ratio
0%
15%
30%
45%
60%
i.
EPS rs
$3.60 0.100
$4.03 0.105
$4.50 0.116
$4.95 0.140
$5.18 0.200
Share Price
$36.00
$38.38
$38.79
$35.36
$25.90