Concept Questions Chapter 16 16.

1a=If Why should financial managers choose the capital structure that maximizes the value of the firm?

Our goal as financial managers is to maximize shareholder wealth. While we will not mathematically prove that maximizing shareholder wealth is equivalent to maximizing firm value, this conclusion holds under the assumptions we maintain. Maximizing firm value also will maximize shareholder wealth. Changes in capital structure benefit the stockholders if and only if the value of the firm increases. Conversely, these changes hurt the stockholders if and only if the value of the firm decreases. This result holds true for capital structure changes of many different types. As a corollary, we can say that managers should choose the capital structure that they believe will have the highest firm value because this capital structure will be most beneficial to the firm's stockholders.
16.2b=What is homemade leverage?

Homemade leverage is a substitution of risks that investors may undergo in order to move from overpriced shares in highly levered firms to those in unlevered firms by borrowing in personal accounts. Mainly attributed to the Modigliani-Miller Theorem, homemade leverage describes the situation where individuals borrowing on the exact same terms as large firms can duplicate corporate leverage through purchasing and financing options.
Questions and Problems: 4=BREAK-EVEN EBIT-Rise Against Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 210,000 shares of stock outstanding. Under plan II there would be 150,000 shares of stock outstanding and $2.28 million in debt outstanding. The interest rate on the debt is 8 percent, and there are no taxes. A. If EBIT is $500,000, which plan will result in the higher EPS. B. If EBIT is $750,000 which plan will result in the higher EPS. C. What is the break-even EBIT?

a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be: EPS = $500,000/210,000 shares EPS = $2.38 Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so: NI = $500,000 .08($2,280,000) NI = $317,600

And the EPS will be: EPS = $317,600/150,000 shares EPS = $2.12 Plan I has the higher EPS when EBIT is $500,000.

b. Under Plan I, the net income is $750,000 and the EPS is: EPS = $750,000/210,000 shares EPS = $3.57 Under Plan II, the net income is: NI = $750,000 .08($2,280,000) NI = $567,600 And the EPS is: EPS = $1,190,000/150,000 shares EPS = $3.78 Plan II has the higher EPS when EBIT is $750,000. c. To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is: EBIT/210,000 = [EBIT .08($2,280,000)]/150,000 EBIT = $ 638,400

6=BREAK-EVEN EBIT AND LEVERAGE- Destin Corp. is comparing two different capital structures. Plan I would result in 10,000 shares of stock and $90,000 in debt. Plan II would result in 7,6000 shares of stock and $198,000. The interest rate on the debt is 10 percent. A. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBOIT will be $48,000. The all equity plan would result in 12,000 shares of stock outstanding. Which of the three plans has to be the highest EPS? The lowest?

B. In part A, what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Is one higher than the other? Why? C. Ignoring taxes, when will EPS be identical for plan I and II?

D. Repeat parts (a), (b), and (c) assuming that the corporate tax is 40 percent. Are the break-even levels of EBIT different from before? Why or why not?

a. The

income statement for each capitalization plan is: Plan 1 Plan 2 All-Equity EPS $ 3.90 $ 3.71 $ 4.00 b. The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is calculated as: EPS = (EBIT RDD)/Shares outstanding This equation calculates the interest payment (RDD) and subtracts it from the EBIT, which results in the net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the interest paid is zero. To find the breakeven EBIT for two different capital structures, we simply set the equations equal to each other and solve for EBIT. The breakeven EBIT between the all-equity capital structure and Plan I is: EBIT = 54,000 And the breakeven EBIT between the all-equity capital structure and Plan II is: EBIT = $54,000 The break-even levels of EBIT are the same because of M&M Proposition I. c. Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT, we get: EBIT = $54,000 This break-even level of EBIT is the same as in part b again because of M&M Proposition I. d. The income statement for each capitalization plan with corporate income taxes is: I $ 2.34 II $ 2.23 All-equity $ 2.40

EPS

Plan II still has the highest EPS; the all-equity plan still has the lowest EPS. We can calculate the EPS as: EPS = [(EBIT RDD)(1 tC)]/Shares outstanding This is similar to the equation we used before, except that now we need to account for taxes. Again, the interest expense term is zero in the all-equity capital structure. So, the breakeven EBIT between the all-equity plan and Plan I is:

EBIT = $54,000 The breakeven EBIT between the all-equity plan and Plan II is: EBIT = $54,000 And the breakeven between Plan I and Plan II is: EBIT = $54,000 The break-even levels of EBIT do not change because the addition of taxes reduces the income of all three plans by the same percentage; therefore, they do not change relative to one another.