Assume that you have just been hired by XYZ, a consulting firm that specializes
ID: 2788402 • Letter: A
Question
Assume that you have just been hired by XYZ, a consulting firm that specializes in analyses of firms’ capital structures. Your boss has asked you to examine the capital structure of Sunshine Deli and Sub Shop (SDSS), which is located adjacent to the campus. According to the owner, sales were $1,350,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. As a result, EBIT totaled $500,000. Because the university’s enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, SDSS pays out all earnings as dividends. The management group owns 50% of the stock, which is traded in the over-the-counter market.
SDSS currently has no debt—it is an all equity firm—and its 100,000 shares outstanding sell at a price of $20 per share. The firm’s marginal tax rate is 40%. On the basis of statements made in your finance class, you believe that SDSS’s shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea, but to provide support for the suggestion.
Amount Borrowed $0 250 500 750 1,000 Id 10.0% 11.0 13.0 16.0 15.0% 15.5 16.5 18.0 20.0 If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. You plan to complete your report by asking and then answering the following questions (1) (2) (1) (2) What is business risk? What factors influence a firm's business risk? What is operating leverage, and how does it affect a firm's business risk? What is meant by the terms financial leverage and financial risk? How does financial risk differ from business risk? a. b c. Now, develop an example that can be presented to SDSS's management. As an illustration, consider two hypothetical firms, Firm U, with zero debt financing, and Firm L, with $10,000 of 12% debt. Both firms have $20,000 in total assets and a 40% marginal tax rate, and they face the following EBIT probability distribution for next year: EBIT Probabilit 0.25 0.50 0.25 $2,000 3,000 4,000Explanation / Answer
a) 1) Business risk is referred to the probability of not meeting the estimated profit expectations or encountering loss rather than profit. A firm's business risk is affected by: price per unit item, volume of the sales, competitive environment, input costs, government regulations and the economic condition prevelant.
2) Company tends to make loss owing to its fixed costs and not the variable costs, as the variable costs depends on the quantity produced. The operating leverage refers to the proportion of the total costs of the firm that is fixed. Higher operating leverage aims at a higher earnings variability and higher beta.
Degree of operating leverage = %change in EBIT/ % change in Revenue
More the operating leverage more will be the firms business risk.
b) 1) Financial leverage refers to the amount of debt used to buy more assets. It is used to reduce the usuage of equity. However, it leads to greater financial risk since it becomes difficult to repay debts.
Financial risk refers to the probability of the shareholders losing money when they invest their funds in a company that has debt, in the case of the company's cash flow being inadequate to meet its liabilities.
2) Business risk refers to the ability of a firm to generate enough profits so as to meet its operating expenses. Financial risk refers to a company's ability to meet its debt obligations.
c) The EBIT for the next year = 0.25*2000+0.5*3000+0.25*4000= $3000
The cost of equity for unleavered firm, U = keu = EBIT/ Market value of equity = 15%
Value of firm U = (1-t)*EBIT/ksu ; t= marginal tax rate
= 0.6* 3000/0.15 = $12000
For firm L i.e. the levered firm: According to the MM theory with corporate tax, the financial leverage will increase the firm's value as interest on debt is a tax deductible expense.
So, Value of firm L = Value of firm U + Tax benefits = $12000+$(0.4*10000) = $16,000.
Hence, as the value of the levered firm increases so shareholders are better off with debt, as this will lead to an increase in their EPS.