Question

Long-term debt offers advantages and disadvantages to the issuing firm and to the investor in debt securities. Examine the following two statements and indicate whether each represents an advantage or a disadvantage to the or the investor issuer By being classed as creditors, debtholders Debt securities can increase the issuer's have priority in cash flows and assets as earnings per share, everything else remaining constant compared with shareholders. Does the preceding statement indicate an Does the preceding statement indicate an advantage investor in debt financing? or a disadvantage to the issuer or the advantage or a disadvantage to the issuer or the investor in debt financing? Disadvantage to the investor Advantage to the issuer Advantage to the investor Advantage to the investor Financial theory states that the use of debt financing (also called financial leverage) increases the borrowing firm's earnings per share (EPS)-assuming that everything else remains constant. Use the following example to prove or disprove the hypothesis: Assume that Marston Manufacturing Company generates annual sales of $2,125,000 using total assets of $500,000 It has an operating profit margin (EBIT/sales) of 45%, a tax rate of 35%, and 100,000 shares of common stock outstanding. These shares have a par value of $5 per share. Currently, the company is financed solely with common stock, but its management is considering selling sufficient debt to bring its debt ratio to 45%. These debt securities, which will carry an interest rate of 15%, will be used to repurchase an equal value of shares of common stock, with the shares valued at their par value. Given this information, answer the questions in the following table: Presale Information What is the firm's current net income? $621,563 What is the firm's current earnings per share? $6.22 Postsale Information How many shares of common stock will the firm have outstanding if it sells its new debt? What will be the firm's earnings per share if it sells the new debt?

Answer 1

By being classified as creditors, debtholders have priority in cash flows and assets as compared with shareholders. - This is an advantage to the investor as periodic cash flows (interest payments) to the investor are paid first and in case of bankruptcy, they have first right to the cash flows from sale of assets, compared to the shareholders. Debt securities can increase the issuer's earnings per share, everything else remaining constant - This is an advantage to the issuer as its earnings per share can increase due to the beneficial effect of financial leverage on ROE.

	Formula	Pre sales
Annual sales (S)		2,125,000
Total assets (A)		500,000
Operating profit margin (m)		45%
Tax rate (r)		35%
Number of common shares (n)		100,000
Par value of common share (p)		5
Operating profit (EBIT)	m*S	956,250
Net income (NI)	EBIT*(1-r)	621,563
EPS	NI/n	6.22
		Post sales
Debt issued (D)	45%*A	225,000
Equity €	A-D	275,000
Shares bought back (s)	D/p	45,000
Share outstanding (N)	n-s	55,000
Annual interest payment (IP)	15%*D	33,750
Net income (NI)	(EBIT-IP)*(1-r)	599,625
EPS	NI/N	10.90