Question

4. (20 marks). Assume there is no tax and the book to market ratio equals 1 Current capital structure Debt: zero. Equity: $200,000, total number of shares: 5,000. EBIT: Normal $21,000; Expansion -20% higher; Recession 25% lower. Proposed capital structure Debt: $50,000. Cost of debt: 8%. Proceeds are used for purchase of equity. (a) Calculate EPS under each of the three economic scenarios before debt is is- sued. Calculate the percentage changes in EPS when the economy expands or contracts with the current capital structure (b) Repeat part (a) with the proposed capital structure. (c) What is the degree of financial leverage for the proposed structure?

Answer 1

Part (a)
	Existing Capital structure
	Normal		Expansion		Recession
			(20% higher)		(25% lower)
EBIT	21000		25200		15750
Less : Interest	0		0		0
Net income	21000		25200		15750
No. of shares	5000		5000		5000
EPS (Net income/No. of shares)	4.2		5.04		3.15
Change in eps			0.84		-1.05
% change in eps			20		-25
(0.84/4.2 *100 ) (-1.05/4.2 *100)
So, change in eps under Expansion is +20% and in recession is -25%.
Part (b)
Proceeds from debt		$50,000
Book value per share = 200000/5000=		$40
Book value and market value ratio equals 1. So market price per share is also $40.
So, no. of shares purchased = 50,000 / 40 =		1250
New no. of shares = 5000-1250 =		3750
	Proposed Capital structure
	Normal		Expansion		Recession
			(20% higher)		(25% lower)
EBIT	21000		25200		15750
Less : Interest (50,000*8%)	-4000		-4000		-4000
Net income	17000		21200		11750
No. of shares	3750		3750		3750
EPS (Net income/No. of shares)	4.533333		5.653333		3.133333333
Change in eps			1.12		-1.4
% change in eps			24.71		-30.88
(1.12/4.5333 *100 ) (-1.4/4.5333) *100)
So, change in eps under Expansion is + 24.71% and in recession is -30.88%
(C )
Degree of financial leverage = EBIT / (EBIT - Interest)
= 21000/17000
	1.24
So, Degree of financial leverage under proposed capital structure is 1.24.