Part 1: Southern Inc. has EBIT of $3,500,000, and total capital of $20,000,000 that is 15% debt. There are 1,700,000 shares outstanding, which sell at book value. The firm pays 10% interest on its debt and is subject to a combined tax rate of 40%. Southern plans to restructure its capital to 60% debt.
a. Make a simple calculation that indicates whether at the current level of profitability more debt will enhance results? Draw a conclusion in fifteen words or less.
b. Calculate EPS, and DFL at the current and proposed structures using the following worksheet:
($000 except for EPS, DFL and Shares)
Current Proposed
EBIT $3,500 $3,500
Interest -------- -------
EBT ------- -------
Tax ------- -------
NI ------- -------
DEBT ------- ------
EQUITY ------- --------
TOT CAP $20,000 $20,000
SHARES 1,700,000
EPS ------- --------
DFL ------ -------
c. Use your results to point out two conflicting influences the change will have on share price.
Part 2) Alasco Inc.'s fixed operating costs are $20.8 million and its variable cost ratio is 0.30. The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. Revenues are $32.2 million. Compute Alasco's degree of total leverage (DTL).
Part 3) New Generation Enterprises has an EBIT of $3.5 million, can borrow at 15% interest, and pays combined provincial and federal income taxes of 40%. It currently has no debt and is capitalized by equity of $20 million. The firm has 2 million shares of common shares outstanding that trade at book value. Calculate New Generation's NI, ROE, and EPS currently and at capital structures that have 20%, 40%, 60%, and 80% debt. Compare the EPS at the different leverage levels, and the amount of change between levels as leverage increases. What happens to the effect of more debt as leverage increases from a little to a lot?