What No to Do
Extra Business and Financial Risk Problems 1. | Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $20 million in assets, has $4 million in EBIT, and is in a 40% tax bracket. Firm HL however, has a debt-to-asset ratio of 50% and pays 12% interest on its debt, whereas LL has a 30% debt-to-asset ratio an pays only 10% interest on its debt. Neither firm uses preferred stock. a. Calculate the return on equity (ROE) for each firm. LL: 14. 6%, HL: 16. % b. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt-to-asset ratio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROE for LL. 16. 5%| 2. | Olinde Electronics Inc. produces stereo components that sell at P = $100 per unit. Olinde’s fixed costs are $200,000, variable costs are $50 per unit, 5,000 components are produced and sold each year, EBIT is currently $50,000, and Olinde’s assets (all equity financed) are $500,000.
Olinde can change its production process by adding $350,000 to assets and $50,000 to fixed operating costs. This change would (1) reduce variable costs per unit by $10 and (2) increase output and sales by 2,000 units, but (3) the sales price on all units would have to be lowered by 5% to permit sales of the additional output. Assume Olinde has losses from previous years, therefore it does not have to pay taxes for the foreseeable future and that the company currently has no debt. The company’s cost of capital is 14%. a. Should Olinde make the change?
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Why or why not? Yes, ROA=24. 29% b. Would Olinde’s break-even point increase or decrease if it made the change? New BE: 4,545 c. Suppose Olinde had to borrow the $350,000 at an interest rate of 10% to make the investment. Find the ROA of the investment. Should Olinde make the change if debt financing must be used? ROA=14. 29%, yes| 3. | The Severn Company plans to raise a net amount of $270 million to finance new equipment in early 2013. Two alternatives are being considered: Common stock may be sold to net $60 per share, or bonds yielding 12% may be issued.
The balance sheet and income statement of the Severn Company before the financing are as follows: Severn Company: Balance Sheet as of December 31, 2012(Millions of Dollars)| Current assets| $ 900. 00| | Notes payable| $ 255. 00| Net fixed assets| 450. 00| | Long-term debt (10%)| 697. 50| | | | Common stock, $3 par| 60. 00| | | | Retained earnings| 337. 50| Total assets| $1,350. 00| | Total liabilities and equity| $1,350. 00| Severn Company: Income Statement for Year Ended, December 31, 2012(Millions of Dollars)| Sales| $2,475. 00|
Operating costs| 2,227. 50| Earnings before interest and taxes (EBIT)| $ 247. 50| Interest on short-term debt| 15. 00| Interest on long-term debt| 69. 75| Earnings before taxes (EBT)| $ 162. 75| Taxes (40%)| 65. 10| Net income| $ 97. 65| The probability distribution for annual sales is as follows: Probability| Annual Sales(Millions of Dollars)| 0. 30| $2,2502,7003,150| 0. 40| | 0. 30| | Assuming that EBIT equals 10% of sales, calculate earnings per share (EPS) under the debt financing and the stock financing alternatives at each possible sales level.
Then calculate expected EPS under both debt and stock financing alternatives. Also calculate the debt-to-asset ratio and the time-interest-earned (TIE) ratio at the expected sales level under each alternative. The old debt will remain outstanding. Which financing method do you recommend? [Hint: Notes payable should be included in both the numerator and the denominator of the debt-to-asset ratio. ]EPSdebt: 0. 30, $3. 24; 0. 40 $4. 59; 0. 30 $5. 94; E(EPS)=$4. 59E(TIE)debt : 2. 30x; Debt/Assets = 75. 5% EPSstock: 0. 30, $3. 43; 0. 40, $4. 54; 0. 30 $5. 64; E(EPS)=$4. 54; E(TIE)stock: 3. 19x; Debt/Assets=58. 8%|