Solve problems: 14-1, 14-2, 14-3, 14-5

A companys fixed operating costs are $500,000, its variable costs

are $3.00 per unit, and the products sales price is $4.00. What is the companys breakeven
point; that is, at what unit sales volume will its income equal its costs?

Fixed Cost $ 5,000,000

Variable Cost 3 per unit
Sale Pric 4

BE=FC/SP-VC

Assuming 5000000 Units, FC per Unit will be $1.00 1

So at 5000000 Units the Company will achieve in break-even point.

OPTIMAL CAPITAL STRUCTURE Jackson Trucking Company is in the process of setting its
target capital structure. The CFO believes that the optimal debt ratio is somewhere between
20% and 50%, and her staff has compiled the following projections for EPS and the stock
price at various debt levels:
Debt Projected EPS Projected Stock Price
20 3.2 35
30 3.45 36.5
40 3.75 36.25
50 3.5 35.5

Assuming that the firm uses only debt and common equity, what is Jacksons optimal
capital structure? At what debt ratio is the companys WACC minimized?

The optimal capital structure for Jacksons stock price is maximized at a 30% debt-to-
capital ratio, the firms optimal capital structure is 30% debt and 70% equity.
RISK ANALYSIS
a. Given the following information, calculate the expected value for Firm Cs EPS. Data
for Firms A and B are as follows: E(EPSA) $5.10, and sA $3.61; E(EPSB) $4.20,
and sB $2.96.
Probability
0.1 0.2 0.4 0.2 0.1
Firm A: EPS a $ (1.50) $ 1.80 $ 5.10 $ 8.40 $ 11.70
Firm B: EPS b $ (1.20) $ 1.50 $ 4.20 $ 6.90 $ 9.60
Firm C: EPS c $ (2.40) $ 1.35 $ 5.10 $ 8.85 $ 12.60

b. You are given that sC = $4.11. Discuss the relative riskiness of the three firms earnings.

E(EPS)a 5.1
SD a 3.61

E(EPS)b 4.2
SD B 2.96

E(EPS)C $ 5.10
SD c 4.11

As per the SD Firm B is least risky as compared to others and Firm C is most riskiest.
FINANCIAL LEVERAGE EFFECTS Firms HL and LL are identical except for their leverage
ratios and the interest rates they pay on debt. Each has $20 million in assets, has $4 million
of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt ratio
(D/A) of 50% and pays 12% interest on its debt, whereas LL has a 30% debt ratio and pays
only 10% interest on its debt.
a. Calculate the rate of return on equity (ROE) for each firm.
b. Observing that HL has a higher ROE, LLs treasurer is thinking of raising the debt ratio
from 30% to 60% even though that would increase LLs interest rate on all debt to 15%.
Calculate the new ROE for LL.

Firm HL Firm LL
Asseste 20 20
EBIT 4 4
Tax Rate 40% 40%
D/A 50 30
Int 12% 10
EBT 2.8 3.4 6
NI 1.68 2.04

ROE 16.8% 14.6%

NEW ROE
Firm HL Firm LL
Asseste 20 20
EBIT 4 4
Tax Rate 40% 40%
D/A 50 60
Int 12% 15%
EBT 2.8 2.2 12
NI 1.68 1.32

ROE 16.8% 16.5%