FINANCIAL LEVERAGE Gentry Motors Inc.

a producer of
turbine generators is in this situation: EBIT... |

magicwriter16

FINANCIAL LEVERAGEGentry Motors Inc., a producer of turbine generators, is in this situation: EBIT = $4
million, tax rate = T = 35%, debt outstanding = D = $2 million, rd= 10%, rs= 15%, shares of stock outstanding
= N0= 600,000, and book value per share = $10. Because Gentrys product market is stable and the company
expects no growth, all earnings are paid out as dividends. The debt consists of perpetual bonds.a. What are
Gentrys earnings per share (EPS) and its price per share (P0)?b. What is Gentrys weighted average cost of
capital (WACC)?c. Gentry can increase its debt by $8 million to a total of $10 million, using the new debt to
buy back and retire some of its shares at the current price. Its interest rate on debt will be 12% (it will have to
call and refund the old debt), and its cost of equity will rise from 15% to 17%. EBIT will remain constant.
Should Gentry change its capital structure? Why or why not?d. If Gentry did not have to refund the $2 million
of old debt, how would this affect the situation? Assume that the new and the still outstanding debt are equally
risky, with rd= 12%, but that the coupon rate on the old debt is 10%.e. What is Gentrys TIE coverage ratio
under the original situation and under the conditions in Part c of this question?
a) EBIT $4,000,000 Less: Interest ($2,000,000 x 10%) $200,000 EBT (Earnings before Tax) $3,800,000
Less: Taxes (35%) $1,330,000 PAT (Profit after Tax) $2,470,000 Earnings per share (EPS) = PAT (Profit after
Tax) / Shares of stock outstanding (N0) = $2,470,000 / 600,000 = $4.1167 per share Price per share (P0) =
Earnings per share (EPS) / Cost of equity (rs) = $4.1167 / 15% = $27.44 b) Weighted average cost of capital
(WACC) = [rd(1-tax) x Wd] + (rs x Ws) = [10% (1-0.35) x $2 million / $8 million] + (15% x $6 million / $8
million) = 1.625% + 11.25% = 12.875% c) EBIT $4,000,000 Less: Interest ($10,000,000 x 12%) $1,200,000
EBT (Earnings before Tax) $2,800,000 Less: Taxes (35%) $980,000 PAT (Profit after Tax) $1,820,000 Shares
bought and retired = Debt/P0 = $8,000,000 / $27.44 = 291,545 New Outstanding Shares = 600,000 291,545
= 308,455 New Earnings per share (EPS) = PAT (Profit after Tax) / New Outstanding Shares = $1,820,000 /
308,455 = $5.90 per share New Price per share (P0) = New Earnings per share (EPS) / New Cost of equity (rs)
= $5.90 / 17% = $34.71 The price per share has increased; hence Gentry should change its capital structure. d)
In this case, the companys net income would be higher by (12% – 10%) x $2,000,000…

x (1-0.35) = $26,000 because its interest charges would be lower. The new price would be as follows: P0 =
[($1,820,000 + $26,000) / 308,455] / 17% = $35.20 In the first case, in which debt had to be refunded, the
bondholders were compensated for the increased risk of the higher debt position. In the second case, the old
bondholders were not compensated; their 10% coupon perpetual bonds would now be worth $100 / 12% =
$833.33, i.e. $1,666,667 in total, which is below the old debt value of $2,000,000 by $333,333. The
stockholders would have a gain of ($35.20 – $34.71) x 308,455 = $151,143. This gain to the stockholders will
be at the expense of the old bondholders. e) TIE coverage ratio = EBIT / Interest Original TIE coverage ratio =
$4,000,000 / $200,000 = 20 times New TIE coverage ratio = $4,000,000 / $1,200,000 = 3.33 times

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