Task: Evaluating McGraw Industries’ Capital Structure
McGraw Industries, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm’s management has been instructed by its board to institute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value.
In this regard, the firm’s chief financial officer (CFO), Ron Lewis, has been charged with evaluating the firm’s capital structure. Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital structure, Lewis has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures—A (30% debt ratio) and B (50% debt ratio)—that he would like to consider.
(a)Capital Structure
Source of Capitol Current A (30% debt) B (50%
(10% debt) debt)
Long-term debt $1,000,000 $3,000,000 $5,000,000
Coupon 9% 10% 12%
Interest Rate(b)
Common Stock 100,000 70,000 40,000
Shares shares shares
Return on Equity© 12% 13% 18%
a) These structures are based on maintaining the firm’s current level of $10,000,000 of total financing.
b) Interest rate applicable to all debt.
c) Market-based return for the given level of risk.
Problem:
On the basis of the graph in part b, which capital structure will maximize McGraw’s earnings per share (EPS) at its expected level of EBIT of $1,200,000? Why might this not be the best capital structure?