|
ABC Corp has $200,000 worth of capital structure
out of which 100% is equity. The firm has 10,000 common shares outstanding
@ a current stock price of $20 / share. The management is considering
issuing $80,000 of debt (bonds) with 15% annual coupon interest. The
company predicts 3 economic scenarios in the following year:
| |
Recession |
Good |
Boom |
| EBIT |
$25,000 |
$50,000 |
$75,000 |
Using the below data, calculate:
1) Return on Equity (ROE)
2) Degree of Financial Leverage (DFL)
3) Indifference EBIT
a) Firm with 100% Equity
100% equity = $200,000
i) Return on Equity
= EBT / Equity Value
| Recession |
Good |
Boom |
| 25000 / 200,000 |
50000 / 200,000 |
75000 / 200,000 |
| = 125% ROE |
= 25% ROE |
= 37.5% ROE |
ii) Degree of Financial
Leverage = EBIT / EBT
| Recession |
Good |
Boom |
| 25000 / 25000 |
50000 / 50000 |
75000 / 75000 |
| = 1 |
= 1 |
= 1 |
b) Firm with $80,000 Debt
Total Capital Structure = $200,000
Debt Issued (Junk Bonds) = (80,000)
Value of Remaining Equity = $120,000
Interest Expense = $80,000 x 15% = $12000
| |
Recession |
Good |
Boom |
| EBT (EBIT - Interest Expense) |
25000 - 12000
= 13000 |
50000 - 12000
= 38000 |
75000 - 12000
= 63000 |
| Return on Equity (ROE) |
13000 / 120000
= 10.83% |
38000 / 120000
= 31.67% |
63000 / 120000
= 52.5% |
| Degree of Financial Leverage |
25000 / 13000
= 1.92 |
50000 / 38000
= 1.32 |
75000 / 63000
= 1.19 |
| |
No Debt |
With Debt |
|
| Indifference EBIT |
EBIT - 0
10000 |
= EBIT - 12000
6000 |
|
| Indifference EBIT |
6000 EBIT = 10000 (EBIT - 12000)
6000 EBIT = 10000EBIT - 120000000
120000000 = 4000EBIT
EBIT = 120000000 / 4000
EBIT
= $30,000 |
|
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