Case Cost Capital Structure Capital and Leverage

STUDENT : Aille Kimberly COURSE CODE : AC46200 SEMESTER/ SEASSIONS : 2022/2023 Sessions STUDY CASE COST CAPITAL, STRUCTURE CAPITAL, AND LEVERAGE Campus Deli Inc. Assume that you just was hired as the business manager of Campus Deli (CD), which lies close to campus. Sales are $1,100,000 a year then; variable costs are 60% of sales; and fixed costs are $40,000. By therefore, EBIT totaled $400,000. Due to registration restricted university, EBIT expected to be constant over time to time. Because there is no expansion capital necessary, CD pay all income as dividend. Asset is $ 2 million, and 80,000 shares outstanding again. Management group owns about 50% of the shares, which traded in the overthe-counter market. CD currently has no debt it is company equity and 80,000 the stock sells for 25 per share, which is also a value book. rates tax federal-plus-state company is 40%. Based on statement which made in your financial text you believe that CD shareholders will better if some debt financing used. When you suggest this to boss new you, he encouraged you for chase idea, but for give support for suggestions. In today's market, level risk free, is 6% and premium market risk 6%. The unlevered beta cd, is 1.0. CD currently has no debt, so that cost equity (and WACC) is 12%. If company recapitalize, debt will issued, and fund load will be used to buy back shares. Shareholders, in turn, will use fund which provided by purchase return for buy equity in company food fast serve other which similar with CD. You planned for finish report you with ask and then answer the following questions. Answer: [Show S13-1 through S13-3 here.] Business risk is that risk attached in operation company if no use debt. Risk a company's business is affected by many factors, including these: (1) Variability in request for the output, (2) Variability in the price at which its output can be sold, (3) Variability in price the input, (4) Ability company for adapt output prices when input prices change, (5) Total operating leverage used by company, and (6) Factor risk special (such as potential liability of the product for company drug or cost potential accident nuclear for utility with generator nuclear). (2) What is operating leverage, and how does it affect? Answer: [Show S13-4 to S13-6 here.] Operating leverage is so far where cost still used in operation company. If percentagewhich is higher than the firm's total fixed costs, and therefore is not decreases when demand falls, then the firm is said to own high operating leverage. Other things that are constant, are getting bigger leverage company operations, increasingly big the business risk. B. (1) Answer: What is meant by the terms financial leverage and financial risk? [Show S13-7 here.] Financial leverage refers to decisions company to finance with fixed income securities, such as debt and preferred stock. Financial risk is an additional risk, in on and in on risk business which attached on company, borne by shareholders as a result of the company's decision to finance with debt. B. (2) Answer: How does financial risk differ from business risk? [Show S13-8 here.] As we have discussed above, business risk depending on the number factor like variability sales and expenses, and leverage operation. Financial risk, on the other hand, depends only on one factor amount capital income still which used company. C. Now, to develop an example that can be presented to CD management as an illustration, consider two hypothetical companies: Company U, with zero debt financing, and Company L, with $10,000 of 12% debt. Both companies have $20,000 in total assets and a 40% combined federal and state tax rate, and they have (1) Probability s EBIT 0.25 $2,000 0.50 3,000 0.25 4,000 Solving the partial income statement and company ratios in Table IC 13 Table IC 13-1. Report Profit Make a loss and Ratio Asset Equity $20,000 $20,000 Company u $20,000 $20,000 $20,000 $20,000 $20,000 $10,000 Probability Sale 0.25 Rp 100,000 0.50 0.25 Rp100,000 $12,000 0.25 Rp100,000 Pass. Cost EBIT 4,000 int. (12%) EBT Tax (40%) Profit clean BEP DEER TIE E(BEP) E(ROE) E(TIE) BEP ROE TIE 6,000 Rp Rp 30,000,000 3,000,000 0 0 Rp Rp 30,000,000 3,000,000 800 1,200 Rp Rp 1,500,000 1,500,000 10.0% 6.0% 15.0% 9.0% 8,000 4,000 Rp 100,000 Rp 30,000.00 0 0 1,200 Rp $ 800 100,000 1,600 Rp $ 2,500,000 20.0% 12.0% 320 480 10.0% 4.8% 1.7 Company L $20,000 $20,000 $10,000 $10,000 0.50 0.25 Rp $12,000 100,000 6,000 8,000 Rp Rp 3,000,000 100,000 $ $ % % 15.0% 9.0% % 3.5% % 2.1% 0 1,200 Rp 10,000.0 00 1,120 Rp 1,500.00 0 20.0% 16.8% 3.3 10.8% 2.5 4.2% 0.6 Answers: [Show S13-9 up to S13-12 in here.] Here is statement complete: Asset Equity $20,000 $20,000 Probability EBIT 0.25 Company u $20,000 $20,000 $20,000 $20,000 $20,000 $10,000 Company L $20,000 $20,000 $10,000 $10,000 0.50 0.25 0.25 0.50 Rp Rp Rp Rp Rp 30,000,000 3,000,000 100,000 30,000.00 3,000,000 0 0 0 0 1,200 1,200 Rp Rp Rp $ 800 Rp 30,000,000 3,000,000 100,000 1,500,000 int. (12%) EBT Tax (40%) Profit clean 800 1,200 1,600 Rp Rp Rp $ 1,500,000 1,500,000 2,500,000 BEP DEER TIE 10.0% 6.0% 15.0% 9.0% 20.0% 12.0% 320 480 Rp 1,500,000 10.0%15.0%20.0% 4.8%10.8%16.8% 1.7 2.5 15.0% 9.0% 15.0% 10.8% 2.5 BEP 3.5% 2.1% 0 3.5% 4.2% TIE Answers: Rp 100,000 720 E(BEP) E(ROE) E(TIE) ROE 0.25 0 1,200 Rp 10,000.0 00 1,120 Rp 1,500.00 3.3 0.6 [Show S13-13 until S13-15 in here.] Conclusion from analysis: 1. Strength income base company, BEP = EBIT / Total asset,No affected by leverage finance. 2. Company L has ROE expected higher: E(ROE U ) = 0.25(6.0%) + 0.50(9.0%) + 0.25(12.0%) = 9.0%. E(ROE L ) = 0.25(4.8%) + 0.50(10.8%) + 0.25(16.8%) = 10.8%. By Because That, use leverage finance has increase profitability Which expected to holder share. The tax savings lead to a higher expected ROE L high. (If company use debt, share more risk, which then causes RD and RS increase. With RD the higher, interest increases, resulting in interest tax savings increase.) 3. Company L has range OBE wider, and standard ROE deviation which is higher, indicates that returns expected higher is accompanied by a higher risk. Specifically: ROE (Unlevered) = 2.12%, And CV = 0.24. ROE (Levered) = 4.24%, than CV = 0.39. With thereby, in meaning risk which stand alone, Company Ltwo time riskier than U company - risk the business is 2.12%, but the stand-alone risk is 4.24%, so that risk finances is 4.24% - 2.12% = 2.12%. 4. When EBIT = $ 2,000, ROE U > ROE L, and leverage own impact negative on profitability. However, on the level the EBIT expected, ROE L > ROE U. 5. Leverage will always increase the expected ROE if ROA which expected exceed cost debt after tax. In here E(ROA) = E(Unlevered ROE) = 9.0% > r d (1 – T) = 12%(0.6) = 7.2%, so use debt increase ROE which are expected. 6. Finally, note that very large TIE ratio (no defined, or very large) if no debt is used, but relatively low If debt 50% used. TIE Which expectedwill more big from 2.5 if less debt is used, but smaller if leveraged improved. D. After speaking with a local investment banker, you obtained the following: estimated cost of debt at different debt levels (in Amount Borrow $ 0 250 500 750 1,000 Debt/Assets Ratio 0.000 0.125 0.250 0.375 0.500 Debt/Equity Ratio 0.0000 0.1429 0.3333 0.6000 1.0000 Bond Ratings — AA A BBB BB rd — 8.0% 9.0 11.5 14.0 Now consider the Optimal capital structure for CD. (1) To begin, define the terms optimal capital structure and target capital Answer: [Show S13-16 here.] Capital structure optimal is structure capital in where benefit leverage related tax exactly offset by cost related to debt risk. In an optimal capital structure, (1) total value company is maximized, (2) WACC is minimized, and price per maximized stock. The target capital structure is a mixture of debt, preferred stock, and common equity with which the company planned for increase capital. D. Answer Why are CD's bond rating and cost of debt dependent on the amount? : Financial risk is the additional risk placed on the holder common stock as a result of a decision to finance with debt. Conceptually, shareholders face a number of risks which stuck in operation company. If a company uses debt (financial leverage), this concentrates on business risk on holder share normal. Financing with debt increase level return which expected for investment, but leverage also increases possibility loss big, so that thereby. Increase the risk borne by shareholders. Because the amount of money borrowed increases, company improve the risk so that ranking bond company decrease and cost debt increase. D. Assume that shares can be repurchased at the current market price of Rp 1,500,000 per share. Calculate CD's expected EPS and TIE at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000. How many shares Answer: [Show S13-17 to S13-25 here.] Analysis for debt levels which currently considered (in thousand dollar and share) showedin below: On D = $0: EPS = EBIT TIE = Interest [EBIT r d (D)] (1 = T) Shares circulated = $400,000(0.6 ) = $3.00. 80,000 . On D = $ 250,000: Share which bought return = $ 250,000 / $ 25 = 10,000. Remaining shares outstanding = 80,000 – 10,000 = 70,000. (Notes: Calculation EPS and TIE in thousand dollar.) EPS = 70 TIE = $20 $400 = 20 [$400 0.08 ($250)](0. 6) = $3.26. . On D = $ 500,000: Stocks that bought come back = $ 500,000 / $ 25 = 20,000. Waste stock which circulated = 80,000 – 20,000 = 60,000. (Notes: Calculation EPS And TIE in thousand dollar.) EPS = TIE = $45 [$400 0.09($500)](0. 6) 60 $400 = 8,9 = $3.55. . On D = $ 750,000: Share which bought return = $ 750,000 / $ 25 = 30,000. Remaining outstanding shares = 80,000 – 30,000 = 50,000. (Notes: Calculation EPS and TIE There is in thousands dollars.) EPS = Tie = $86.25 [$400 0.115($750)](0. 60) 50 $400 = $3.77. . = 4,6 On D = $ 1,000,000: Share which bought return = 1,000,000 usd/25 = 40,000. Remaining shares outstanding = 80,000 – 40,000 = 40,000. (Notes: Calculation EPS and TIE in thousand of dollar.) EPS = TIE = $140 D. [$400 0.14($1,000)]( 0.60) 40 $400 = 2,9 = $3.90. . Using the Hamada equation, what is the cost of equity if CD recapitalizes with Answers: [Show S13-26 until S13-30 in here.] rRF _ = 6.0% b U = 1.0 Rates tax = 40.0% Amount r M – rRF _ = 6.0% Total asset = 2,000 USD Debt/Assets Ratio b Borrow a $ 0 250 500 750 1,000 0.00% 12.50 25.00 37.50 50.00 Debt/Equity US ratio c Beta d 0.00% 14.29 33.33 60.00 100.00 1.00 1.09 1.20 1.36 1.60 Lever rd s an 12.00% 12.51 13.20 14.16 15.60 Notes: data which given in problem. b Counted as amount which borrowed shared with total asset. c Calculated as the amount borrowed divided by equity (total assets reduced amount which borrowed). d Counted use equality hamada, b L = b U [1 + (1 – T)(D/E)]. e Calculated using CAPM, R.S = rRF + (r M – r RF )b, given level risk free, market risk premium, and using beta levers as is counted with Hamad's equation. D. Given only the discussed levels of debt, what capital structure minimizes Answerb: [Show S13-31 And S13-32 inhere.] rRF _ = 6.0% b U = 1.0 r M – rRF _ = 6.0% Total asset = 2,000 USD Rates tax = 40.0% Amount Borrow da $ 0 250 500 Ratio Debt/As s ets b 0.00% 12.50 25.00 Equity/As s ets ratio c 100.00% 87.50 75.00 Debt/E qui ty Ratio d leverage d Beta e 0.00% 14.29 33.33 1.00 1.09 1.20 rf s f 12.00% 12.51 13.20 dr a rd(1 – T) WACCg 0.0% 8.0 9.0 0.0% 4.8 5.4 12.00% 11.55 11.25 750 1,000 37.50 50.00 62.50 50.00 60.00 100.00 1.36 1.60 14.16 15.60 11.5 14.0 6.9 8.4 11.44 12.00 Notes: data which given in problem. b Counted as amount which borrowed shared with total asset. c Counted as 1 – D/A. d Calculated as the amount borrowed divided by equity (total assets reduced amount which borrowed). e Counted use hamada equation, b L = b U [1 + (1 – Q)(D/E)]. f Calculated using the CAPM, r s = r RF + (r M – r RF)b, given the degree of freedom risk, market risk premium, and using the beta lever as calculated with equality hamada. g Counted use equality WACC, WACC = w d r d (1 – Q) + w c r s . WACC CD is minimized on a capital structure consisting of 25% debt and 75% equity, or WACC as big 11.25%. D. (6) What will be the price of the new shares if CD recapitalizes with debt of Rp 2,500,000? $500,000? $750,000? $1,000,000? Remember that the Answer: [Show S13-33 here.] We can count price share constant growth as DPS divided by rs minus g, where gis the expected dividend growth rate: P 0 = D 1 / (r s – g). Because in this case all the income is paid to the holder shares, DPS = EPS. Furthermore, because there is no income hijacked return, EBIT company estimated No will grow, So g = 0. Following result: rs Level Debt DPS $ $3.00 12.00% 3.26 3.55 12.51 13.20 0 250,000 500,000 Price Share Rp 250,000 26.03 26.89* 750,000 1,000,000 3.77 3.90 14.16 15.60 26.59 25.00 *Maximum D. 7) Is EPS maximized at the level of debt that maximizes the stock price? Answer: [Show S13-34 here.] We've seen that EPS Keep going increase in outside level debt optimal $ 500,000. By Because That, focusing on EPS when making capital structure decisions is incorrect -temporary EPS No take into account costs differential debt, That No calculating the increased risk to be borne by the holder equity. D. (8) Given only the discussed levels of debt, what is CD's optimal capital structure? Answer: [Show S13-35 here.] Capital structure with $500,000 in debt produce price share highest, $ 26.89; by because that, that is which best from which considered. D. Answer: (9) What is the WACC at the optimal capital structure? Level debt beginning: Debt/Total asset = 0%, so totals asset = Equity beginning = 25 USD 80,000 shares = 2,000,000,000 shares. WACC = $2,000,000 $500,000 (9%)(0.60) + $1,500,000 $2,000,000 (13.2% = 1,35% + 9,90% = 11,25%. Note : If We own (1) use price equilibrium for buyreturn share and (2) use weight mark market for count WACC, so we can sure that the WACC on the capital structure that maximizes price will be minimum. With use price purchase $ 25 which constant, and weight mark book, inconsistency can creep enter. D Answer: Suppose you find that CD has more business risk than you initially estimated. Explain how this will affect the analysis [Show S13-36 here.] If the company has risks business which more high, then, at any level of debt, the possibility of financial distress will more tall. Investors will recognize this, and RD and RS will more tall from estimation beginning. This no showed in analysis this, but results finallyis structure capital which optimal with debt which more a little. On the contrary, risk business which more low will lead on structure capital optimal which covers more a lot of debt. F. What factors should a manager consider when defining their role? Answers: [Show S13-37 And S13-38 in here.] Because it's hard for measure capital structure decisions, managers consider the factors evaluation following when make structure decisions capital: 1. Ratio debt average for company in industry they. 2. Ratio pro form TIE on structure capital which different in scenario which different. 3. Attitude giver loan/ institution rating. 4. Reserve capacity loan. 5. Effect financing to control. 6. Structure asset. 7. Rates tax which expected. 8. Attitude management. 9. Condition market. 10. Condition internal company. 11. Leverage operation company. 12. Level growth company. 13. Profitability company. Picture IC 13-1. Connection between structure capital and price share Mark Share Company 0 D1 D2 Leverage, D/A G. Place labels on Figure IC 13-1, then discuss the graphic as you might use it to Answers: [Show S13-39 And S13-40 in here.] Use debt possiblecompany for get savings tax from deduction flower. So, the use of some debt is good; however, a possibility bankruptcy increases the cost of using debt. At the level of debt higher and higher, bankruptcy risk increases, bring along the costs associated with potential difficulties finance. Customers cut back on purchases, key employees leave, and so on.There is some points, generally Far in lower ratio debt 100%, in where problem which related with potency bankruptcy more from offset savingstax from debt. Theoretically, the optimal capital structure is found at the point where marginal tax savings equal to bankruptcy-related costs marginal. However, analyst no can identify matter this with precision for company certain, or for company on generally. Analysts can help managers determine the optimal range for ratio debt company they, but decision structure capital still more judge than based on calculation which appropriate. H. Answers: How do the presence of asymmetric information and signals affect capital? [Show S13-41 to S13-44 here.] Asymmetric information concept is based on the premise that the choice of management financing signal to investors. Companies with investment opportunities good company will not want to share the benefits with new shareholders, so they will tend to finance with debt. Company with prospects bad, on the other hand, will want to finance with stock. Investors know this, so when a company is big and mature announce stock offering, investors perceive this as a bad news signal, and the stock price decreased. Companies know this, so they try avoid having to sell new common stock. It means maintain reserve borrowing capacity so that when investing which well come along, they can financed with debt.