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Problem 16-6 Problem 16-12

Fundamentals of Corporate Finance by Ross, Westerfield, and Jordan -- Fifth Edition

Copyright © 2000 Irwin/McGraw-Hill and KMT Software, Inc. (www.kmt.com)

File: 766207418.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024

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File: 766207418.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024

 Fundamentals of Corporate Finance
Ross, Westerfield, and Jordan -- Fifth Edition

Problem 16-6 Objective

Calculate EBIT break-even.

Student Name:
Course Name:
Student ID:
Course Number:

The El Nino Co. is comparing two different capital structures. Plan I would result in 800 shares of stock and
$14,000 in debt. Plan II would result in 900 shares of stock and $7,000 in debt. The interest rate on the
debt is 11 percent.

a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $6,000. The
all-equity plan would result in 1,000 shares of stock outstanding. Which of the three plans has the highest
EPS? The lowest?

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity
plan? Is one higher than the other? Why?

c. Ignoring taxes, when will EPS be identical for Plans I and II?

d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 38 percent. Are the break-even
levels of EBIT different from before? Why or why not?

Solution
Instructions
Enter data and formulas to solve the problem.

a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $5,000. The
all-equity plan would result in 1,000 shares of stock outstanding. Which of the three plans has the highest
EPS? The lowest?

I II All-equity
Debt $14,000 $7,000 0
Shares 800 900 1,000

EBIT $6,000 $6,000 $6,000

Interest FORMULA FORMULA
Net Income #VALUE! #VALUE! $6,000
EPS FORMULA FORMULA FORMULA

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity
plan? Is one higher than the other? Why?

I II All-equity
EBIT
Interest 0
Net Income #VALUE! #VALUE! $0
EPS #VALUE! #VALUE! $0.00

c. Ignoring taxes, when will EPS be identical for Plans I and II?

I II
EBIT
Interest
Net Income #VALUE! #VALUE!
EPS #VALUE! #VALUE!

d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 38 percent. Are the break-even
levels of EBIT different from before? Why or why not?

I II All-equity
Debt $14,000 $7,000 0
Shares 800 900 1,000

EBIT $6,000 $6,000 $6,000

Interest FORMULA FORMULA 0
Taxes FORMULA FORMULA FORMULA
Net Income $6,000 $6,000 $6,000
EPS FORMULA FORMULA FORMULA

File: 766207418.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024

 Fundamentals of Corporate Finance
Ross, Westerfield, and Jordan -- Fifth Edition

Problem 16-12 Objective

Calculate WACC.

Student Name:
Course Name:
Student ID:
Course Number:

Foredebtful Industries has a debt-equity ratio of 2.5. Its WACC is 12 percent, and its cost of debt is 12
percent. The corporate tax rate is 35 percent.

a. What is Foredebtful's cost of equity capital?

b. What is Foredebtful's unlevered cost of equity capital?

c. What would the cost of equity be if the debt-equity ratio were 1.5? What if it were 1.0? What if it were
zero?

Solution
Instructions
Enter data and formulas to solve the problem.

a. What is Dreadnaught's cost of equity capital?

Weights Cost WAAC

Equity #VALUE! FORMULA #VALUE!
Debt FORMULA FORMULA #VALUE!
#VALUE!

b. What is Dreadnaught's unlevered cost of equity capital?

`
Unlevered Rate on
Cost of Debt D/E
Capital Capital Ratio Tax Rate
12% 2.5 35%

-19.5% <-- If this is 22.5% you have entered the correct value for the unlevered cost of
equity capital.

c. What would the cost of equity be if the debt-equity ratio were 1.5? What if it were 1.0? What if it were zero?
Instruction: (Enter the debt-equity ratio in the cell below and record the cost of equity in the answer cells
below).

Debt-equity ratio of:

Weights Cost WAAC
Equity 100% 12.00% 12.00%
Debt 0% 7.80% 0.00%
12.00%

Answer
Debt-equity ratio of: 1.5 1.0 0
Cost of equity

Problem: 16-12 Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024