Question

Integrative----Optimal capital structure   The board of directors of Morales​ Publishing, Inc., has commissioned a capital structure study. The company has total assets of $ 39,500,000. It has earnings before interest and taxes of $ 7,900,000 and is taxed at a rate of 23%.

a. Create a spreadsheet showing values of debt and equity as well as the total number of​ shares, assuming a book value of $25 per share.

b. Given the​ before-tax cost of debt at various levels of​ indebtedness, calculate the yearly interest expenses.

c. Using EBIT of $ 7,900,000​, a 23% tax​ rate, and the information developed in parts ​(a​) and ​(b​)​, calculate the most likely earnings per share for the firm at various levels of indebtedness. Mark the level of indebtedness that maximizes EPS.

d. Using the EPS developed in part ​(c​)​, the estimates of required​ return, rs and the equation P0 = EPS / rs​, estimate the value per share at various levels of indebtedness. Mark the level of indebtedness in the following table that results in the maximum price per​ share, P0.

e. Prepare a recommendation to the board of directors of Morales Publishing that specifies the degree of indebtedness that will accomplish the​ firm's goal of optimizing shareholder wealth. Use your findings in parts ​(a​) through ​(d​) to justify your recommendation.

Answer 1

Part (a)

Please see the table below. Please be guided by the second row to understand the mathematics. All financials are in $.

Proportion of debt	Total assets	Debt	Equity	Nos. of shares
Wd	A	D = Wd x A	E = A - D	N = E/25
0%	39,500,000	-	39,500,000	1,580,000
10%	39,500,000	3,950,000	35,550,000	1,422,000
20%	39,500,000	7,900,000	31,600,000	1,264,000
30%	39,500,000	11,850,000	27,650,000	1,106,000
40%	39,500,000	15,800,000	23,700,000	948,000
50%	39,500,000	19,750,000	19,750,000	790,000
60%	39,500,000	23,700,000	15,800,000	632,000

Part (b)

Proportion of debt	Total assets	Debt	Before tax cost of debt	Yearly interest expenses
Wd	A	D = Wd x A	Rd	I = Rd x D
0%	39,500,000	-	0.00%	-
10%	39,500,000	3,950,000	7.50%	296,250
20%	39,500,000	7,900,000	8.00%	632,000
30%	39,500,000	11,850,000	9.00%	1,066,500
40%	39,500,000	15,800,000	11.00%	1,738,000
50%	39,500,000	19,750,000	12.50%	2,468,750
60%	39,500,000	23,700,000	15.50%	3,673,500

Part (c)

Proportion of debt	Total assets	Debt	Equity	Nos. of shares	Before tax cost of debt	Yearly interest expenses	EBIT	EBT	EAT	EPS
Wd	A	D = Wd x A	E = A - D	N = E/25	Rd	I = Rd x D		EBIT - I	EBT x (1 - 23%)	EAT / N
0%	39,500,000	-	39,500,000	1,580,000	0.00%	-	7,900,000	7,900,000	6,083,000	3.85
10%	39,500,000	3,950,000	35,550,000	1,422,000	7.50%	296,250	7,900,000	7,603,750	5,854,888	4.12
20%	39,500,000	7,900,000	31,600,000	1,264,000	8.00%	632,000	7,900,000	7,268,000	5,596,360	4.43
30%	39,500,000	11,850,000	27,650,000	1,106,000	9.00%	1,066,500	7,900,000	6,833,500	5,261,795	4.76
40%	39,500,000	15,800,000	23,700,000	948,000	11.00%	1,738,000	7,900,000	6,162,000	4,744,740	5.01
50%	39,500,000	19,750,000	19,750,000	790,000	12.50%	2,468,750	7,900,000	5,431,250	4,182,063	5.29
60%	39,500,000	23,700,000	15,800,000	632,000	15.50%	3,673,500	7,900,000	4,226,500	3,254,405	5.15

EPS is maximized when proportion of debt is 50%. This has been shown as bold in the table above.

Part (d)

Proportion of debt	Total assets	Debt	Equity	Nos. of shares	Before tax cost of debt	Yearly interest expenses	EBIT	EBT	EAT	EPS	Required return	P0
Wd	A	D = Wd x A	E = A - D	N = E/25	Rd	I = Rd x D		EBIT - I	EBT x (1 - 23%)	EAT / N	Rs	EPS / Rs
0%	39,500,000	-	39,500,000	1,580,000	0.00%	-	7,900,000	7,900,000	6,083,000	3.85	10.0%	38.50
10%	39,500,000	3,950,000	35,550,000	1,422,000	7.50%	296,250	7,900,000	7,603,750	5,854,888	4.12	10.3%	39.97
20%	39,500,000	7,900,000	31,600,000	1,264,000	8.00%	632,000	7,900,000	7,268,000	5,596,360	4.43	10.9%	40.62
30%	39,500,000	11,850,000	27,650,000	1,106,000	9.00%	1,066,500	7,900,000	6,833,500	5,261,795	4.76	11.4%	41.73
40%	39,500,000	15,800,000	23,700,000	948,000	11.00%	1,738,000	7,900,000	6,162,000	4,744,740	5.01	12.6%	39.72
50%	39,500,000	19,750,000	19,750,000	790,000	12.50%	2,468,750	7,900,000	5,431,250	4,182,063	5.29	14.8%	35.77
60%	39,500,000	23,700,000	15,800,000	632,000	15.50%	3,673,500	7,900,000	4,226,500	3,254,405	5.15	17.5%	29.43

The level of indebtedness in the following table that results in the maximum price per​ share, P0 = 30% (please see the row highlighted in yellow)

Part (e)

Because of the leverage, EPS improves and reaches a maximum at 50% leverage. It starts declining after that. Expected return (Rs) increases as the level of leverage increases. Price per share that is an interplay of EPS and R_s improves initially and reaches a peak at 30% leverage. It starts declining then.

The level of indebtedness in the following table that results in the maximum price per​ share, P0 = 30% (please see the row highlighted in yellow in the table of part (d))

Hence,  the degree of indebtedness that will accomplish the​ firm's goal of optimizing shareholder wealth is the level of indebtedness at which share price P0 is maximized i.e. 30% leverage or 30% indebtedness.