Balfour Corp has the following operating results and capital structure ($000). R
ID: 2689292 • Letter: B
Question
Balfour Corp has the following operating results and capital structure ($000). Revenue $6,000 Debt $ 1,200 Cost/Expense 4,500 Equity 8,800 EBIT $1,500 Total $10,000 The firm is contemplating a capital restructuring to 60% debt. Its stock is currently selling for book value at $25 per share. The interest rate is 9%, and combined state and federal taxes are 42%. a. Calculate EPS under the current and proposed capital structures. b. Calculate the DFL under both structures. c. Use the DFLs to forecast the resulting EPS under each structure if operating profit falls off by 5%, 10%, or 25%. d. Comment on the desirability of the proposed structure versus the current one as a function of the volatility of the business. e. Is stock price likely to be increased by a change to the proposed capital structure? Discuss briefly.Explanation / Answer
Balfour Corp has the following operating results and capital structure ($000).
Revenue $6,000 Debt $ 1,200
Cost/Expense 4,500 Equity 8,800
EBIT $1,500 Total $10,000
The firm is contemplating a capital restructuring to 60% debt. Its stock is currently selling for book value at $25 per share. The interest rate is 9%, and combined state and federal taxes are 42%.
a. Calculate EPS under the current and proposed capital structures.
b. Calculate the DFL under both structures.
c. Use the DFLs to forecast the resulting EPS under each structure if operating profit falls off by 5%, 10%, or 25%.
d. Comment on the desirability of the proposed structure versus the current one as a function of the volatility of the business.
e. Is stock price likely to be increased by a change to the proposed capital structure? Discuss briefly.
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INCOME STATEMENT
Current Proposed
EBIT $1,500 $1,500
Interest (9%) 108 540
EBT $1,392 $ 960
Tax (42%) 585 403
EAT $ 807 $ 557
BALANCE SHEET
Debt $ 1,200 $ 6,000
Equity 8,800 4,000
Capital $10,000 $10,000
#Shares = Eq/BV per share
$8,800,000/$25 = 352,000
$4,000,000/$25 = 160,000
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a. EPS = EAT / # Shrs
Current: $807/352 = $2.29
Proposed: $557/160 = $3.48
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b. DFL = EBIT / EBT
Current: $1,500/$1,392 = 1.08
Proposed: $1,500/$960 = 1.56
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c. % DEPS = DFL (% DEBIT)
Fcst EPS = EPS (1 - % DEBIT)
Current Proposed
% D EBIT % DEPS Fcst EPS % DEPS Fcst EPS
5% 5.4% $2.17 7.8% $3.21
10% 10.8% $2.04 15.6% $2.94
25% 27.0% $1.67 39.0% $2.12
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d. EPS is higher but more variable under the proposed structure. However, at a 25% reduction in EBIT, EPS is still better under the proposal than under the old structure.
Hence if operating profitability isn't expected to vary much, the proposal may be a good idea.
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e. We can't say for sure because the ultimate impact on stock price depends on investors' subjective feelings about risk and return trade-off.
However, it looks likely that the impact would be favorable if EBIT isn't expected to vary more than 25%.
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