(2) What does this example illustrate concerning the impact of financial leverag
ID: 2574953 • Letter: #
Question
(2) What does this example illustrate concerning the impact of financial leverage on expected rate of return and risk?
d. With the preceding points in mind, now consider the optimal capital structure for SDSS.
(1) To begin, define the term optimal capital structure.
(2) Describe briefly, without using numbers, the sequence of events that would occur if SDSS decided to change its capital structure to include more debt.
(3) Assume that shares could be repurchased at the current market price of $20 per share. Calculate SDSS’s expected EPS and TIE at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000. How many shares would remain after recapitalization under each scenario? [EPS = (Net income)/(outstanding shares)]
(4) What would be the new stock price if SDSS recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000? Recall that the SDSS pays out all earnings as dividends, so g = 0.
(5) Considering only the levels of debt discussed, what is SDSS’s optimal capital structure?
(6) Is EPS maximized at the debt level that maximizes share price? Why?
(7) What is the WACC at the optimal capital structure?
e. Suppose you discovered that SDSS had more business risk than you originally estimated. Describe how this would affect the analysis. What if the firm had less business risk than originally estimated?
f. What is meant by the terms degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL)? If fixed costs total $40,000 and the company uses $500,000 of debt, what are SDSS’s degrees of each type of leverage? Of what practical use is the degree of leverage concept?
g. What are some factors that should be considered when establishing a firm’s target capital structure?
h. Put labels on the following graph, and then discuss the graph as you might use it to explain to your boss why SDSS might want to use some debt.
(1) Complete the following partial income statements and the set of ratios for Firm L. Firm U Firm L Assets $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $10,000 $10,000 $10,000 Equity 0.25 0.50 0.25 0.25 0.50 0.25 Probability Sales Operating costs $ 6,000 $9,000 $12,000$6,000 $9,000 $12,000 (4,000 (6,000 (8,000 4,000 6,000 (8,000) Interest (1 2%) Earnings before taxes Taxes (40%) Net income ROE = Earnings before interest and taxes $2,000 $ 3,000 $4,000 $2,000 $ 3,000 $ 4,000 $ 2,800 $ 1200$1800 $2400 $480 S S 1680 % 16.8% ( 0) ( 0) (1.200) 1200) $ 2,000 $ 3,000 $4,000 $ 800$ 800 1200 1600 320) (1.120) Net income 60% 9.0% 12.0% 48% Common equity TIEEBIT Expected ROE Expected TIE 1.7x 3.3x Interest 10.8% 2.5x 4.2% 0.6x 90% 2.1% OTIEExplanation / Answer
1) Interest of Firm L 1200
Taxes 720
Net income 1080u
ROE. 10.8%
TIE - 2.5
2) The impact of financial leverage on expected return and risk is that financial leverage is 1.67 and Expected ROE 10.8%
D- 1) Optimum capital structure indicated the best debt to equity ratio for a firm that maximises its value.
2)
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