Question

Janice Underwood, an MBA student in Southeastern University , has been hired as a night manager of Campus Deli and Sub Shop (CDSS), which is located adjacent to the campus. Sales were $ 875,000 last year; variable costs were 60 % of sales; and fixed costs were $ 50,000. Therefore, EBIT totalled $ 300,000. Since the university ‘s enrollment is capped, the store’s EBIT is expected to be constant over time. Since no expansion capital is required, CDSS pays out all earnings as dividends.

CDSS is currently all equity financed, and its 100,000 shares outstanding sell at a price of $ 10 per share. The firm’s tax rate is 34 %. Underwood believes that the firm will be better off if some debt financing is used.She needs some justification for her suggestion. She developed the following estimates of the costs of debt and equity at different debt levels ( in thousands of dollars ):

Amount   borrowed                                    cost of debt                 cost of equity

$     0                                                                  _                               15.0%

   200                                                              10.0%                          15.5

   400                                                              11.0                              16.5

   500                                                              13.0                              18.0

   600                                                              16.0                              20.0

If the firm were recapitalized, the borrowed funds would be used to repurchase stock. Stockholders ,in return, would use the funds provided by the repurchase    to buy equities in other fast food companies similar to CDSS. Underwood needs help in answering the following questions:

1.Calculate CDSS’s expected EPS at debt levels of $0, $ 200,000, $400,000,$ and 600,000. How many shares would remain after recapitalization under each scenario? Assume that shares are repurchased at the current market price of $ 10per share?

2. What would be the stock price under each case defined above?

3.If CDSS’s fixed costs total $ 50,000, what is its degree of operating leverage?

4. What will be CDSS’s degree of financial leverage at a debt level of $ 500,000?

Answer 1

1)

Particulars	Amount($)
Sales	$875,000
less:Variable Cost(60% of sales)	$525000
Contribution(Sales- Vatriable Cost)	$350,000
less:Fixed Cost	$50,000
Profit(EBIT)	$300,000

Calculation of EPS at different Debt Level

EBIT (A)	$300,000	$300,000	$300,000	$300,000
Debt (B)	$0	$200,000	$400,000	$600,000
Cost of debt (C)	0%	10%	11%	16%
Cost of debt Financing (B*C)=D	0	$20,000	$44,000	$96,000
EBT (A-D)=E	$300,000	$280,000	$256,000	204,000
Tax Rate (E*34%)=F	$102,000	$95200	$28160	$69,360
EAT (E-F)=G	$198,000	$184,800	$227,840	$134650
No of shares outstanding (H)	100,000	100,000	100,000	100,000
EPS (G/H)	1.98	1.85	2.28	1.35

Market capitalisation is the total value of company's equity= (No of shares outstanding*Current price)

=(100,000shares*$10)= $10,00,000

iii)Degree of Operating Leverage= (Fixed cost/Total Cost)

Given Fixed cost =$50,000

Variable Cost(60% of sales)

Total Cost=(Fixed cost +Variable cost)

=($50,000+525,000)= $575,000

Degree of Operating Leverage=(50000/575000)*100= 8.70%

iv)CDSS'S Degree of Financial Leverage at a debt level of $500,000

EBIT (A)	$300,000
Debt (B)	$500,000
Cost of debt (C)	13%
Cost of debt Financing (B*C)=D	$65,000
EBT (A-D)=E	$235,000

financial leverage=EBIT/EBT= ( $300,000/235000)= 1.28