Tutorial 8

1) A company’s fixed operating costs are $500,000, its Variable costs are $3.00 per unit and the
product’s sales price is $4.00. What is the company’s breakeven point; that is, at what unit sales
volume will its income equal its costs?

Answer:

F
QBE =
P−V

$500,000
QBE =
$4.00 − $3.00

QBE = 500,000 units.

2) Harley Motors has $10 million assets, which were financed with $2 million of debt and $8
million in equity. Harley’s beta is currently 1.2 and its tax rate is 40%. Use the Hamada equation
to find Harley’s unlevered beta bU.

Answer:

From the Hamada equation, b = bU[1 + (1 – T)(D/E)], we can calculate bU as bU = b/[1 + (1 – T)(D/E)].

bU = 1.2/[1 + (1 – 0.4)($2,000,000/$8,000,000)]
bU = 1.2/[1 + 0.15]
bU = 1.0435.

3) Firms HL and LL are identical except for their leverage ratios and interest rates they pay on
debt. Each has $20 million in assets, has $4million of EBIT, and as 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 30% debt ratio and pays only 10% interest on its debt.

a) Calculate return on equity ROE for each firm.

b) observing that HL has a higher ROE, LL’s treasurer is thing of rising the debt ratio from 30%
to 60% even though that would increases LL’s interest rate on all debt to 15%. Calculate the new
ROE for LL.
Answer:

a. LL: D/TA = 30%.

EBIT $4,000,000
Interest ($6,000,000  0.10) 600,000
EBT $3,400,000
Tax (40%) 1,360,000
Net income $2,040,000

Return on equity = $2,040,000/$14,000,000 = 14.6%.

HL: D/TA = 50%.

EBIT $4,000,000
Interest ($10,000,000  0.12) 1,200,000
EBT $2,800,000
Tax (40%) 1,120,000
Net income $1,680,000

Return on equity = $1,680,000/$10,000,000 = 16.8%.

b. LL: D/TA = 60%.

EBIT $4,000,000
Interest ($12,000,000  0.15) 1,800,000
EBT $2,200,000
Tax (40%) 880,000
Net income $1,320,000

Return on equity = $1,320,000/$8,000,000 = 16.5%.

Although LL’s return on equity is higher than it was at the 30% leverage ratio, it is lower than
the 16.8% return of HL.
Initially, as leverage is increased, the return on equity also increases. But, the interest rate
rises when leverage is increased. Therefore, the return on equity will reach a maximum and
then decline.

4) Tapley Inc. currently has assets of $5 million, has zero debt, is in the 40% federal-plus-state
tax bracket, has a net income of $1 million, and pays out 40% of its earnings as dividends. Net
income is expected to grow at a constant rate of 5% per year, 200,000 shares of stock are
outstanding and the current WACC is 13.40%

The company is considering a recapitalization where it will issue $1 million in debt and
use the proceed to repurchase stock. Investment banker have estimated that the company goes
through with the recapitalization, it’s before-tax cost of debt will be 11% and its cost of equity
will rise to 14.5%.

a) What is the stock’s current price per share (before the recapitalization)?

b) Assuming that the company maintains the same payout ratio, what will be its stock price
following the recapitalization?

Answer:

a. The current dividend per share, D0, = $400,000/200,000 = $2.00. D1 = $2.00(1.05) = $2.10.
Therefore, P0 = D1/(rs – g) = $2.10/(0.134 – 0.05) = $25.00.

b. Step 1: Calculate EBIT before the recapitalization:

EBIT = $1,000,000/(1 – T) = $1,000,000/0.6 = $1,666,667.
Note: The firm is 100% equity financed, so there is no interest expense.
Step 2: Calculate net income after the recapitalization:
[$1,666,667 – 0.11($1,000,000)]0.6 = $934,000.

Step 3: Calculate the number of shares outstanding after the recapitalization:

200,000 – ($1,000,000/$25) = 160,000 shares.

Step 4: Calculate D1 after the recapitalization:

D0 = 0.4($934,000/160,000) = $2.335.
D1 = $2.335(1.05) = $2.45175.

Step 5: Calculate P0 after the recapitalization:

P0 = D1/(rs – g) = $2.45175/(0.145 – 0.05) = $25.8079  $25.81.