Impact and Analysis of leverage

Question 1

Four investors are in the process of forming a new company. The new firm will
produce and distribute computer hardware on a national basis. The hardware will be
aimed at scientific markets and at businesses desiring to install comprehensive
information systems. Private investors have been sourced to finance the new
company. Two financing proposals are being considered. Both these plans involve
the use of some financial leverage; however, one is much more highly levered than
the other plan. Plan A requires the firm to sell bonds with an effective interest rate of
10%. One million dollars would be required in this manner. In addition, under plan A,
$5 million will be raised by selling 1million shares. Plan B also involves raising $6
million. This would be accomplished by raising $1 million from selling ordinary shares
at the same price as in plan A. $5 million will be raised by selling bonds with an
effective interest rate of 12%. In both cases the use of financial leverage is
considered to be a permanent part of the firm’s capital structure, so no fixed maturity
date is used in the analysis. The firm considers a 30% tax rate to be appropriate for
planning purposes.

Required:
Find the EBIT indifference level associated with the two financing plans.
Question 2
A group of close friends has decided to form a small manufacturing company to
produce of solar panels. Two financing plans have been proposed by the investors.

Plan A is an all equity alternative, where 4 million shares will be sold to net the firm
$6 per share.

Plan B involves the use of financial leverage. A debt issue with a 20-year maturity
period will be privately placed. The debt issue will carry an interest rate of 5%, and
the principal borrowed will amount to $12 million. The corporate tax rate is 30%.

Required:

(a) Find the EBIT indifference level associated with the two financing plans.

(b) Which plan will result in a higher EPS when the expected EBIT is above the
indifference level?
Question 3

Use the information below to answer the following questions:

Average selling price per unit $20.00

Variable cost per unit $12.00
Units sold 500 000 units
Fixed costs $1,200,000
Interest expense $150,000

Required:

(a) What is the degree of operating leverage?

(b) What is the degree of financial leverage?
(c) What is the degree of combined leverage?
(d) If sales increase by 10%, what should happen (in terms of percentage change)
to operating income (EBIT)?
(e) If operating income increases by 10%, what should happen (in terms of
percentage change) to EPS?
(f) If sales increase by 10%, what should (in terms of percentage change) be the
effect on EPS?
(g) Calculate the break-even level of units sold.
(h) Calculate the break-even level of sales revenue.
Question 4
The following shows the analytical income statement for Malaysian Enterprises Ltd.
for the financial year just ended.

Analytical Income Statement

Sales $12,000,000
Less: Total Variable Costs $ 8,000,000
Contribution $ 4,000,000
Less: Fixed Costs $ 2,000,000
Earnings before Interest and Tax (EBIT) $ 2,000,000
Less: Interest on Debt (interest rate 5%) $ 500,000
Earnings after Interest on Debt $ 1,500,000
Less: Company Tax (50%) $ 750,000
Earnings after Tax $ 750,000
Preference Dividends (dividend rate 5%) $ 200,000
Earnings attributable to ordinary shareholders $ 550,000

Additional information:

Number of ordinary shares outstanding equals 300,000

Required:

(i) Compute the degree of operating leverage, the degree of financial leverage
and the degree of combined leverage for Malaysian Enterprises Ltd.

(ii) If sales of Malaysian Enterprises Ltd. increase by 20%, by how much (in
percentage) will EBIT and EPS of Malaysian Enterprises Ltd. increase?

(iii) If EBIT of Malaysian Enterprises Ltd. decrease by 10%, by how much will the
EPS of Malaysian Enterprises Ltd. decrease?

(iv) What is Malaysian Enterprises Ltd. break-even point in sales dollars?

Question 5

Data Electronics Ltd is considering additional financing of $20,000 to finance new

diagnostic hardware. It currently has $100,000 of 10% (annual interest) bonds and
100,000 ordinary shares outstanding. The firm can obtain the financing through a
10% (annual interest) bond issue or the sale of 10,000 ordinary shares. The firm has
a 40% tax rate.

Required:
a) Find the EBIT indifference level associated with the two financing plans.
b) Which plan will result in a higher EPS when expected EBIT is above the
indifference level?
c) What is the primary weakness of EBIT-EPS analysis as a financing tool?
Question 6
Texas Industries manufactures a specialised computer chip. Each chip produced
has a variable cost of $10 and sells for $20. The firm’s total fixed operating costs
are $200,000. Texas Industries has a current annual interest charge of $200,000.
The firm has a 30% tax rate and currently sells 100,000 computer chips per year.

Required:

(a) Calculate the firm’s operating break-even point in units.

(b) Compute the degree of operating leverage, the degree of financial leverage
and the degree of combined leverage for Texas Industries.
(c) If sales of Texas Industries increase by 10%, by what percent will EBIT and
EPS of Texas Industries increase?
(d) If EBIT of Texas Industries decreases by 20%, by what percent will EPS of
Texas Industries fall?
(e) What is business risk and financial risk? What are the causes of each of these
risks?
Cost of Capital

Question 7
Compute the cost for the following sources of financing based on the following
data:
a) A bond has a $1000 par value (face value) and a contract or coupon
interest rate of 10%, paid annually with a $1045 market value. The bonds
mature in 10 years. Estimate the after-tax cost of bonds if the company
tax rate is 30%. The firm has issued 1,000 bonds in total.
b) A company's ordinary shares paid a 50 cent dividend last year. Dividend
per share has grown at a rate of 8% per year. This growth rate is
expected to continue into the foreseeable future. The company. The
price of this share is now $5.50. The company has issued 500,000
shares
c) Preference shares are paying a 9% dividend on a $10.00 par value and
have a current market price of $13. The company has issued 50,000
preference shares.
d) Calculate the market values of debt, equity and preference shares and
the WACC.
Capital Budgeting

Question 8
One year ago, your company purchased a machine used in its manufacturing
operations for $2,200,000. You have just recently discovered that a newly developed
machine is now available that offers a number of technological advantages when
compared to the existing machine. This new machine can be purchased for
$3,000,000. It can be depreciated on a straight-line basis over 10 years. It is not
expected to have any salvage value but it estimated that $200,000 will be required in
clean-up and disposal costs at the end of the 10 years. The new machine will also
require an initial increase in working capital of $150,000 which will be recovered in
year 10. You also expect that the new machine will produce a gross margin (revenue
minus expenses other than depreciation) of $500,000 per year for the next 10 years.
The current machine is expected to produce a gross margin of $200,000 per year.
The current machine is being depreciated on a straight-line basis over a useful life of
11 years, and has no salvage value. The existing machine could be sold now for
$1,500,000. Your company’s tax rate is 30%, and the cost of capital for this type of
investment is 10%.

Required:
(i) Calculate the initial cash outlay for replacing the existing machine with the
new machine.
(ii) Calculate the incremental on-going free cash flows relating to the
replacement.
(iii) Calculate the terminal cash flows relating to the new project.
(iv) What does the NPV rule say you should do? (Calculate the NPV and interpret
your answer).
Risk and Return
Question 9
You are considering making an investment in Visual Enterprises Ltd. Your research
indicates the company is in a sound financial position. You are unsure of what you
may expect as a return from this investment and have gathered the following historical
returns for the last 4 years.

Past Returns (%)

-2
8
11
15

Required:

(a) Calculate the expected return and standard deviation for Visual Enterprises
using the data provided above.
(b) The total risk associated with a share investment has two parts. What is the
distinction between these two parts?
(c) When explaining diversification concepts and the analysis of risk, why is the
correlation between asset returns important?
Question 10
(a) The last three years of returns for a share are as follows:

1 2 3
15% -4% 5%
Required:
(a) Calculate the average annual return
(b) Calculate the standard deviation of the share’s return

Question 11
You hold a portfolio with the following securities:

Security % of Portfolio Beta Return

ABC 20% 1.20 16%
XYZ 35% 1.00 12%
WXA 45% 0.85 9%

Required:
(a) Compute the average return for the portfolio.
(b) Compute the beta for the portfolio.

Question 12
Suppose you invest $100,000 and buy 8000 shares of Qantas at $5per share and
1500 shares of Woolworth at $40per share. If Qantas’ share goes up to $6 per
share and Woolworth share falls to $38per share and neither paid dividends, what
return did the portfolio earn based on the initial investment?
Bond Valuation
Question 13

A corporate bond with six years to maturity and a coupon rate of 8% has a par value
of $1000. Interest is paid semi-annually on this bond.

Required:

(a) If you require a return of 10 percent on this bond, what is the value of this
bond to you?
(b) What is the relationship between the required return and the coupon interest
rate that will cause a bond to sell at a discount? At a premium? At its face
value?
(c) Explain what is meant by a bond’s Yield to Maturity (YTM).
(d) What is the approximate yield to maturity for a $1000 par value bond selling
for $1100 pays interest annually and has 10 years to maturity? Assume a
coupon rate of 10%.
Question 14
Lifestyle Ltd has issued A rated corporate bonds with 10 years to maturity and a
coupon rate of 8%. The bonds have a par value of $1000 and interest on these
bonds is paid semi-annually.

Required:

(a) If you require a return of 10% on this bond, what is the value of this bond to
you?
(b) Is it true that the only risk associated with owning a bond is that the issuer will
not make all the payments? Explain.
(c) What is the relationship between the required rate of return and the coupon
interest rate that will cause a bond to sell at a discount? At a premium?
(d) Explain what is meant by a bond’s Yield to Maturity (YTM).
(e) What is the approximate yield to maturity for a $1000 par value Treasury
issued bond selling for $1050, paying interest annually, and having 6 years to
maturity? Assume a coupon rate of 8%.

Question 15
You are considering three investments. The first is a bond that is selling in the
market at $1,200. The bond has a $1,000 par value, pays interest semi-annually at
10%, and is scheduled to mature in 10 years. For bonds of this risk class you
believe that a 12% rate of return should be required. The second investment that
you are analysing is a preference share ($100 par value) that sells for $95 and pays
an annual dividend of $10. Your required rate of return for this share is 10%. The
last investment is an ordinary share ($35 par value) that recently paid
a $5 dividend. The firm's earnings per share have increased from $4 to $8 in 10
years, which also reflects the expected growth in dividends per share for the
indefinite future. The share is selling for $40, and you think a reasonable
required rate of return for the share is 20%.

Required:
(a) Calculate the value of each security based on your required rate of
return.
(b) Calculate the expected return of each security.
Share Valuation
Question 16
Research Ltd’s ordinary shares currently pay an annual dividend of $1.00 per share.
The required return on the shares is 12 percent. Estimate the value of the ordinary
shares under each of the following assumptions about the dividend:

(a) Dividends are expected to grow at an annual rate of 0 percent to infinity

(b) Dividends are expected to grow at a constant annual rate of 4% to infinity

Capital Structure

Question 17
Your firm currently has $100 million in permanent debt outstanding with a 6%
interest rate. Suppose the marginal corporate tax rate is 30%, and that the interest
tax shields have the same risk as the loan. What is the present value of the Tax
Shield?