Complete the following partial income statements and the set of ratios for Firm
ID: 2802485 • Letter: C
Question
Complete the following partial income statements and the set of ratios for Firm L.
Firm U Firm L
Assets $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Equity $20,000 $20,000 $20,000 $10,000 $10,000 $10,000
Probability 0.25 0.50 0.25 0.25 0.50 0.25
Sales $ 6,000 $ 9,000 $12,000 $ 6,000 $ 9,000 $12,000
Operating costs (4,000) (6,000) (8,000) (4,000) (6,000) (8,000)
Earnings before interest and taxes $ 2,000 $ 3,000 $ 4,000 $ 2,000 $ 3,000 $ 4,000
Interest (12%) ( 0) ( 0) ( 0) (1,200) 1,200)
Earnings before taxes $ 2,000 $ 3,000 $ 4,000 $ 800 $ $ 2,800
Taxes (40%) ( 800) (1,200) (1,600) ( 320) (1,120)
Net income $ 1,200 $ 1,800 $ 2,400 $ 480 $ $ 1,680
ROE =Net Income/Common Equity 6.0% 9.0% 12.0% 4.8% % 16.8%
TIE = EBIT/Interest 1.7x x 3.3x
Expected ROE 9.0% 10.8%
Expected TIE 2.5x
ROE 2.1% 4.2%
TIE 0x 0.6x
(2) What does this example illustrate concerning the impact of financial leverage on expected rate of return and risk?
d. With the preceding points in mind, now consider the optimal capital structure for SDSS.
(1) To begin, define the term optimal capital structure.
(2) Describe briefly, without using numbers, the sequence of events that would occur if SDSS decided to change its capital structure to include more debt.
(3) Assume that shares could be repurchased at the current market price of $20 per share. Calculate SDSS’s expected EPS and TIE at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000. How many shares would remain after recapitalization under each scenario? [EPS = (Net income)/(outstanding shares)]
(4) What would be the new stock price if SDSS recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000? Recall that the SDSS pays out all earnings as dividends, so g = 0.
(5) Considering only the levels of debt discussed, what is SDSS’s optimal capital structure?
(6) Is EPS maximized at the debt level that maximizes share price? Why?
(7) What is the WACC at the optimal capital structure?
e. Suppose you discovered that SDSS had more business risk than you originally estimated. Describe how this would affect the analysis. What if the firm had less business risk than originally estimated?
f. What is meant by the terms degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL)? If fixed costs total $40,000 and the company uses $500,000 of debt, what are SDSS’s degrees of each type of leverage? Of what practical use is the degree of leverage concept?
g. What are some factors that should be considered when establishing a firm’s target capital structure?
Explanation / Answer
2) higher the leverge i,e, debt the company has lowever is return to the shareholders, since the details are not clear , it is difficult to answer the question
1) the term optimal capital structure is the debt to equity ratio , that maximizes return the to the company
3) if company changes its capital structure and change it to the debt, the company has to pay interest on the amount borrowed, the debt to equity ratio of the company will be higher than periovious making company dependent more on outside funds
3) SDSS Companys data is not given, however do change the net income of the company by paying additional interest paid (after cosidering tax rate) and divide it by new number of shares of the company
5) WACC is Return on equity * Cost of equity + Return on debt * cost of debt
Remaining answers could not be given as data of SDSS company is not provided
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