FINC1901 Corporate Finance

Tutorial 8 Capital Structure Exercise_Q&A

Cosmetic Manufacturers is contemplating changing the capital structure of the firm.

The firm has $45 million in total assets, earnings before interest and taxes of $7.5
million and is taxed at a rate of 40%.
Complete the following tables showing:

a. The level of debt, equity and number of shares of common stock. The nominal value is
$20 per share
% Number of shares @
Total assets Debt ($) Equity ($)
Debt R20
$45,000,00
0% $ 0 $45,000,000 2,250,000
0
$45,000,00
30% 13,500,000 31,500,000 1,575,000
0
$45,000,00
40% 18,000,000 27,000,000 1,350,000
0
$45,000,00
50% 22,500,000 22,500,000 1,125,000
0
$45,000,00
60% 27,000,000 18,000,000 900,000
0

b. The total debt and interest expense for each level of leverage
%
Total debt ($) Before-tax cost of debt, rd Interest expense ($)
Debt
0% $ 0 0.0% $ 0
30% 13,500,000 9.5% 1,282,500
40% 18,000,000 11.0% 1,980,000
50% 22,500,000 12.5% 2,812,500
60% 27,000,000 15.5% 4,185,000
c. The earnings per share (EPS) for each level of leverage
% Interest Net Number EP
EBIT EBT Taxes
Debt expense income of shares S
$7,500,00 7,500,00 3,000,00 4,500,00 2,250,00
0% 0 2.00
0 0 0 0 0
$7,500,00 1,282,50 6,217,50 2,487,00 3,730,50 1,575,00
30% 2.37
0 0 0 0 0 0
$7,500,00 1,980,00 5,520,00 2,208,00 3,312,00 1,350,00
40% 2.45
0 0 0 0 0 0
$7,500,00 2,812,50 4,687,50 1,875,00 2,812,50 1,125,00
50% 2.50
0 0 0 0 0 0
$7,500,00 4,185,00 3,315,00 1,326,00 1,989,00
60% 900,000 2.21
0 0 0 0 0
d. The estimates of the company share price for each level of leverage. Note: the required rate
of return (r s ¿ is given
%
EPS rs P0
Debt
0% 2.00 10.0% $20.00
30% 2.37 11.4% $20.79
40% 2.45 12.6% $19.44
50% 2.50 14.8% $16.89
60% 2.21 17.5% $12.63
 FINC1901 Corporate Finance
Tutorial 8 Capital Structure Exercise_Q&A

e. Based on your answers to the previous parts, which debt ratio would you recommend to
the company? Explain your answer.
The EPS will be maximized when a 50% debt ratio is implemented, but the risk is rather high
as is evident in the required rate of 14.8%. However, the main goal of financial managers
is to maximize owner wealth and this will be done by implementing a 30% debt ratio (P0
= $20.79).