(A) How much financial risk would the company face at each of the three-alternat
ID: 2614500 • Letter: #
Question
(A) How much financial risk would the company face at each of the three-alternative debt-to-capital ratios presented in the exhibit below. (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM)
(B) How much value could Hill Country create for its shareholders at each of the three alternative debt levels? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM)
(C) What debt-to-capital structure would you recommend as optimal for Hill Country Snack Foods? Why?
Pro Forma 2011 Financial Information for Alternative Capital Structures Pro Forma 2011 for (in million except for per share data and financial ratios) Actual 20% 40% 60% 2011 Debt-to-Capital Debt-to-Capital Debt-to-Capital Sales $1,364.6 $1,364.6 $1,364.6 $1,364.6 Operating income (EBIT) $151.3 $151.3 $151.3 $151.3 Interest Expense $0.0 $4.1 $12.8 $33.5 Income before income taxes $151.3 $147.2 $138.5 $117.8 Income taxes $53.7 $52.3 $49.2 $41.8 Net income $97.6 $94.9 $89.3 $76.0 Dividends paid to common stockholders $28.8 $28.5 $26.8 $22.8 Common shares outstanding 33,883,400 29,709,777 26,983,400 24,476,604 Earnings per share $2.88 $3.19 $3.31 $3.11 Dividends per share $0.85 $0.96 $0.99 $0.93 Interest coverage ratio (times) n/a 36.90 11.82 4.52 Debt $0.0 $145.0 $290.0 $435.0 Owners equity (book value) $780.1 $580.1 $435.1 $290.1Explanation / Answer
(A)
The use of debt in the capital structure has a direct bearing on financial risk. Interest which is a fixed and compulsory payment is independent of financial result i.e profit or loss of a company. The variability of EPS with changes in operating profit gives a measure of financial leverage which is called degree of financial leverage(DFL) and thus financial risk. Another alternative method to calculate degree of financial leverage is :
DFL = EBIT/EBIT-Interest Payment
Given the inputs, DFL under actual and three different scenarios are calculated i.e when debt to equity is 20%, debt to equity is 40% and debt to equity is 60%:
Acual
Scenario I
Scenario II
Scenario III
Debt to capital
NA
20%
40%
60%
DFL
1
1.03
1.09
1.28
(B)
The use of debt in the capital structure would create value to the shareholder only if the return on equity(ROE) is higher than the interest payment. Thus the management of a company seeks to use financial leverage to magnify shareholders’ return.
ROE is calculated as:
ROE= EBIT/Owners' equity
Given the inputs, ROE is calculated on actual and three different debt to capital ratios:
Acual
Scenario I
Scenario II
Scenario III
Debt to capital
NA
20%
40%
60%
Return on Equity
13%
16%
21%
26%
Interest rate*
NA
3%
4%
8%
*Interest rate=Interest expense/Debt
It is clear from the calculation that the company Hill Country is able to generate return on equity which is higher than Interest rate and thus the leverage gain.
(C)
It is evident that under debt to capital ratio 60% DFL is 1.28 as compared to 1.09 & 1.03 when debt to capital ratios are 40% and 20% respectively which means that the company faces more of financial risk given the 60% debt to capital ratio, However the company enjoys higher RoE which is favourable to shareholder. Hence a trade off between risk-return is to be sought which depends on aggressive or conservative strategy of the company.
Acual
Scenario I
Scenario II
Scenario III
Debt to capital
NA
20%
40%
60%
DFL
1
1.03
1.09
1.28
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.