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MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 18 LONG-TERM FINANCING DECISIONS


I. Questions 1. Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy. 2. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature. 3. Operating leverage primarily affects the operating income of the firm. At this point, financial leverage takes over and determines the overall impact on earnings per share. 4. At progressively higher levels of operation than the break-even point, the percentage change in operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical -- as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less. 5. The point of equality only measures indifference based on earnings per share. Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt. 6. From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find additional funds and increase its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost. II. Multiple Choice 1. D 6. C 18-1

Chapter 18

Long-term Financing Decisions

2. 3. 4. 5.

D B A A

7. B 8. B

III. Problems PROBLEM 1 (UNION BUSINESS FORMS) Cost (after-tax) 7.05 10.0 13.0 Weights 35% 15 50 Weighted Cost 2.45% 1.50 6.50 10.45%

Debt (Kd)..................................... Preference shares (Kp)................. Ordinary equity (Ke) retained earnings................... Weighted average cost of capital (Ka) PROBLEM 2 (HOLLY CORP.) Weighted average cost of capital Debt Preference Shares Ordinary Shares =

6.60% x 30% = = 9.11% x 10% = 11.0% x 60% = WACC

1.98% = 0.90% 6.60% 9.48%

PROBLEM 3 (UNION BRICK) The optimal capital budget is P230,000 (Projects A, B, and C). All the projects IRR exceeded the average marginal cost.

PROBLEM 4 (PIZZA EXPRESS) ksp = kap = 10% + 1.38 (5%) = 16.9%. 0.5 (12.0%) (0.6) + 0.5 (16.9%) = 12.05%.

But kp = IRR = 13.0%. 18-2

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Accept the project, its required rate of return is 12.05%. PROBLEM 5 (HAPPY GILMORE CO.) Debt = 12.4% (1 - 35%) = 8.06% x 35% x 10% = = 2.82% 0.98%

Q (P - VC) Preference Shares = Q (P - VC) - FC - I

10,000 (P50 - P20) Ordinary Shares = + - P150,00055% = 9.35% x - P60,000 10,000 (P50 - P20) 12% Weighted average cost of capital 13.15%

P4.75 PROBLEM 6 (SNOWBELL COMPANY) P50 - P1.40 Q = 10,000, P = P50, VC = P20, FC = P150,000, I = P60,000 P2.70 Q (P - VC) P54 a. DOL = Q (P - VC) - FC = = = 10,000 (P50 - P20) 10,000 (P50 - P20) - P150,000 10,000 (P30) 10,000 (P30) - P150,000 300,000 P300,000 - P150,000 EBIT EBIT - I P150,000 P90,000 = 300,000 P150,000 = 2.00X

b. DFL

= =

= =

P150,000 P150,000 - P60,000 1.67X

c. DCL

= = 18-3

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= d. BE = =

= =

3.33X

5,000 skates

PROBLEM 7 (PILAK COMPANY) a. INCOME STATEMENTS Return on assets = 10,000 (P30) 10% EBIT = P1,200,000 P300,000 10,000Current - P210,000 Plan D P90,000 Plan E (P30)
EBIT P1,200,000 P150,000 Less: Interest 600,000 1 P50 - P20 EBT 600,000 Less: Taxes (45%) 270,000 EAT 330,000 Ordinary shares 750,000 4 EPS P0.44
1 2 3 4

P150,000 2 960,000 P30 240,000


108,000 132,000 375,000 P0.35

P1,200,000

P1,200,000 300,000 3 900,000 405,000 495,000 1,125,000 P0.44

P6,000,000 debt @ 10% P600,000 interest + (P3,000,000 debt @ 12%) (P6,000,000 - P3,000,000 debt retired) x 10% (P6,000,000 ordinary equity) / (P8 par value) = 750,000 shares Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is equal to the operating return on assets of 10 percent. With Plan D, the cost of increased debt rises to 12 percent, and the firm incurs negative leverage reducing EPS and also increasing the financial risk to Pilak.

b. Return on assets
EBIT Less: Interest EBT Less: Taxes (45%) EAT Ordinary shares EPS

= 5%
Current P600,000 600,000 0 0 750,000 0

EBIT =
Plan D P 600,000 960,000 (360,000) (162,000) P(198,000) 375,000 P(0.53)

P600,000
Plan E P600,000 300,000 300,000 135,000 P165,000 1,125,000 P0.15

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Return on assets = 15%


EBIT Less: Interest EBT Less: Taxes (45%) EAT Ordinary shares EPS Current P1,800,000 600,000 1,200,000 540,000 P 660,000 750,000 P0.88

EBIT =
Plan D P1,200,000 960,000 840,000 378,000 P 462,000 375,000 P1.23

P1,800,000
Plan E P1,800,000 300,000 1,500,000 675,000 P 825,000 1,125,000 P0.73

If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides the best EPS. Plan D is still risky, having an interest coverage ratio of less than 2.0. c. Return on assets
EBIT EAT Ordinary shares EPS
1

= 10%
Current P1,200,000 P 330,000 750,000 P0.44

EBIT =
Plan D P1,200,000 P 132,000 1 500,000 P0.26

P1,200,000
Plan E P1,200,000 P 495,000 2 1,00,000 P0.50

750,000 - (P3,000,000 / P12 per share) = 750,000 - 250,000 = 500,000 750,000 + (P3,000,000 / P12 per share) = 750,000 + 250,000 = 1,000,000

As the price of the ordinary shares increases, Plan E becomes more attractive because fewer shares can be retired under Plan D and, by the same logic, fewer shares need to be sold under Plan E.

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