Question

The Canterbury Coach Corporation has EBIT of $3.62 million, and total capital of $20 million, which is 15% debt. There are 425,000 shares of stock outstanding which sell at book value. The firm pays 12% interest on its debt and is subject to a combined state and federal tax rate of 40%. Canterbury is contemplating a capital restructuring to either 30%, 45%, 60%, or 75% debt. a. At the current level of profitability, will more debt enhance results? Why? In (5000) ROCE = EBIT (1-T)/Debt + Equity = After-tax cost of debt = b. Calculate the EAT, ROE, EPS, and the DFL at the current and proposed structures, and display your results in a systematic table. INCOME STATEMENT Current Proposals 15% 30% 45% 60% Debt Debt Debt Debt 75% Debt EBIT Interest EBT Tax EAT BALANCE SHEEET Debt Equity Capital Shares Book Value ROE EPS DFL = EBIT/EBIT-1) DFL (Ctrl) -

Answer 1

Solution-a Whether more debt will enhance results at current level of profitability ROCE= EBIT*(1-tax)/(Debt + Equity) EBIT= $3.62m Total Capital (Debt + Equity) = $20m Tax rate = 40% Therefore, return on capital employed (ROCE) is as always: ROCE= 3.62*(1-40%)/(20) ROCE= 3.62*(1-40%)/(20) ROCE= 10.86% Also, cost of debt= Interest rate*(1-tax rate) Cost of debt= 12%*(1-0.4) Cost of debt= 7.2% Since, cost of debt is lower than ROCE, the company can take additional debt, invest in business and enhance its results since it will earn more than it will have to shell out in cost of debt

Solution-b Formula Given 75% Debt 3.62 EBIT 1.44 1.8 Interest 12% of debt calculated below Current 15% Debt 3.62 0.36 (Debt*Interest rate, i.e. 3m*12%) 3.26 1.30 1.96 30% Debt 3.62 0.72 (Debt*Interest rate, i.e. 6m*12%) 2.9 1.16 1.74 Proposals 45% Debt L 60% Debt 3.62 3.62 1.08 (Debt*Interest (Debt*Interest rate, i.e. rate, i.e. 9m*12%) 12m*12%) 2.54 2.18 1.02 0.87 1.52 1.31 (Debt*Interest rate, i.e. 15m*12%) EBT |Тах EAT EBIT-interest 40% of EBIT EBT-tax 1.82 0.73 1.09 15 Debt 12 (20m*60%) Capital* debt % (20m*15%) (20m*45%) (20m*75%) 17 11 Equity Capital*(1-debt %) (20m*30%) 14 (20m*(1-30%)) 20 (20m*(1-15%)) (20m*(1-75%)) (20m*(1-45%) 20 (20m*(1-60%)) 20 Capital Given 20 20 Book Value per share [20m*(1-15%)/425000] Equity capital/Book No. of Shares value per share 40 4,25,000 (17,000,000/40) 11.53% (1.96/17) 4.61 (1.96/0.425) 40 3,50,000 (14,000,000/40) 12.43% (1.74/14) 4.97 (1.74/0.35) 40 2,75,000 (11,000,000/40) 13.82% (1.52/11) 5.53 (1.52/0.275) 40 2,00,000 (8,000,000/40) 16.37% (1.31/8) 6.55 (1.31/0.2) 40 1,25,000 (5,000,000/40) 21.8% (1.09/5) 8.72 (1.09/0.125) ROE EAT/Equity Capital EPS EAT/No. of Shares DFL EBIT/EBIT-Interest) 1.11 1.25 1.43 1.66 1.99