Define each of the following terms:
a. Optimal capital structure; target capital structure
b. Business risk; financial risk
c. Financial leverage; operating leverage; operating breakeven
d. Hamada equation; unlevered beta
e. Symmetric information; asymmetric information
f. Modigliani-Miller theories
g. Trade-off theory; signaling theory
h. Reserve borrowing capacity
ST-2 Operating leverage and breakeven analysis Olinde Electronics Inc. produces stereo
components that sell at P $100 per unit. Olinde’s fixed costs are $200,000; variable
costs are $50 per unit; 5,000 components are produced and sold each year; EBIT is cur-
rently $50,000; and Olinde’s assets (all equity financed) are $500,000. Olinde can change
its production process by adding $400,000 to assets and $50,000 to fixed operating costs.
This change would (1) reduce variable costs per unit by $10 and (2) increase output by
2,000 units, but (3) the sales price on all units would have to be lowered to $95 to permit
sales of the additional output. Olinde has tax loss carry-forwards that cause its tax rate
to be zero, it uses no debt, and its average cost of capital is 10 percent.
a. Should Olinde make the change?
b. Would Olinde’s breakeven point increase or decrease if it made the change?
c. Suppose Olinde were unable to raise additional equity financing and had to borrow
the $400,000 at an interest rate of 10 percent to make the investment. Use the Du
Pont equation to find the expected ROA of the investment. Should Olinde make the
change if debt financing must be used?
ST-3 Financial leverage Gentry Motors Inc., a producer of turbine generators, is in this situa-
tion: EBIT $4 million; tax rate T 35%; debt outstanding D $2 million; rd
10%; r s 15%; shares of stock outstanding N0 600,000; and book value per share
$10. Because Gentry’s 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 Gentry’s earnings per share (EPS) and its price per share (P0)?
b. What is Gentry’s 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 percent (it will have to call and refund the old debt), and its cost of
equity will rise from 15 to 17 percent. EBIT will remain constant. Should Gentry
change its capital structure?
d. If Gentry did not have to refund the $2 million of old debt, how would this affect
things? 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 percent.
e. What is Gentry’s TIE coverage ratio under the original situation and under the con-
ditions in part c of this question?
Why do wide variations in the use of financial leverage occur both
across industries and among individual firms in each industry?
