Question

Norwich Industries, an established manufacturer of printing equipment, expects its sales
to remain flat for the next three to five years due to both weak economic outlook and an
expectation of little new printing technology development over that period. Base on that
scenario the firm’s management has been instructed by the Board of directors to
institute that will allow it to operate more efficiently, earn higher profits, and most
important maximize shareholder wealth. In this regard, the firm’s chief financial officer
(CFO), Ron Lewis, has been tasked to evaluate the firm’s capital structure, dividend
policy, and possible capital projects. Currently the firm has a fixed total capital of $10,
000,000, which is made up of 10 percent debt and 90 percent equity. The firm has
100,000 outstanding ordinary shares and no preference shares. Although Lewis feels
that the firm’s current policy of paying out 60 percent of each year’s earnings in
dividends is appropriate, he believes that the current capital structure may lack
adequate financial leverage. In order to evaluate the firm/s capital structure, Lewis is
considering two alternative capital structures – A (30 percent debt ratio) and B (50
percent debt ratio). The interest rate on current debt is 10 percent and is believed to
remain the same. Lewis expects the firm’s current earnings before interest and taxes
(EBIT) to remain at $1,200,000. The firm has a tax rate of 40 percent.
Norwich is considering replacing one of its printers with either of two printers – printer A
or printer B. Printer A is highly automated, computer controlled; printer B is less
expensive and uses standard technology. In order to analyze these alternatives, Lewis
prepared estimates of the initial investment and the relevant incremental cash inflows
associated with each printer. These are summarized in the following table:

Printer A	Printer B
Initial investments	$660,000	$360,000
Year	Profits after tax	Cash inflows	Profits after tax	Cash Inflows
1	$5,000	$128,000	$5,000	$88,000
2	10,000	182,000	15,000	120,000
3	20,000	166,000	10,000	96,000
4	65,000	168,000	20,000	86,000
5	210,000	450,000	100,000	207,000

Note that Lewis planned to analyze both printers over a five -year period. At the end of that time
the printer will be sold, thus accounting for the large fifth-year cash inflow. Lewis decided to
apply the firm’s 13 percent cost of capital when analyzing the printers. Norwich required a
maximum payback period of 4.0 years.
Suppose the following table summarizes the net present values and associated probabilities for
the various outcomes for the two printer alternatives.

Net present value
Market outcome	Probability	Printer A	Printer B
Very poor	5%	-$6,000	$500
Poor	15%	2,000	4,500
Average	60%	8,500	8,000
Good	15%	15,000	12,500
Excellent	5%	23,000	16,500

(a) How much debt is used in the current and proposed capital structures? (b) What is the expected return on assets?
(c) Assuming that the share price stays the same, calculate the earnings per share for the
three financing alternatives. (d) What is the level of EBIT at the point of indifference? (e) Find the dividend cover for the three financing alternatives (f)Use the payback period to access the acceptability and relative ranking of each printer. (g) Use the following capital budgeting techniques to access the acceptability and relative ranking of each printer: (h) (i) (j) Discounted payback period (DPP) Net present value (NPV) Profitability index (PI) (k)Summarize the preferences indicated by the techniques used in (a) and (b) and indicate which printer you would recommend, if either, if the firm has (i) unlimited funds or (ii) capital rationing. What the most likely NPVs? (l) Calculate the expected NPV for each printer. (m) Calculate the range of NPVs for each printer. (n) Calculate the standard deviations of NPV for each printer. (o) Which printer has higher relative risk.

Answer 1

Ans. (a)

Total Capital = $10,000,000

Currently the capital comprises of 10% Debt and 90% Equity.

So, the value of current Debt = 10% of $10,000,000

                                                = $1,000,000

Calculation of Value of Debt with alternative capital structures – (Assuming that the additional Debt will be offset by reducing the Equity)

Value of Debt with A (30 percent debt ratio) = = 30% of $10,000,000

                                                = $3,000,000

Value of Debt with A (50 percent debt ratio) = = 50% of $10,000,000

                                                = $5,000,000

Ans. (b)

Expected EBIT = $1,200,000 (Without considering purchase of the new printer)

Calculation of expected return on assets under two alternative capital structures – A (30 percent debt ratio) and B (50 percent debt ratio) is given below:

Sl. No.		Option A (30% Debt)	Option B (50% Debt)
1	Expected EBIT	$1,200,000	$1,200,000
2	Total Debt	$3,000,000	$5,000,000
3	Expected Interest Exp. (10%)	$300,000	$500,000
4	Expected EBT (1-3)	$900,000	$700,000
5	Tax (40%)	$360,000	$280,000
6	Net Income (4-5)	$540,000	$420,000
7	Total Assets	$10,000,000	$10,000,000
8	Expected Return on Assets (6/7)*100	5.40%	4.20%

Ans. (c)

Calculation of the earnings per share for the three financing alternatives (Assuming that the additional Debt will be offset by reducing the Equity):

Value of Equity = $9,000,000/-

No. of Current shares at 10% Debt = 1,00,000

Price per share = $9,000,000 / 1,00,000 = $90

Sl. No.		Option 1 (10% Debt)	Option 2 (30% Debt)	Option 3 (50% Debt)
1	Expected EBIT	$1,200,000	$1,200,000	$1,200,000
2	Total Debt	$1,000,000	$3,000,000	$5,000,000
3	Expected Interest Exp. (10%)	$100,000	$300,000	$500,000
4	Expected EBT (1-3)	$1,100,000	$900,000	$700,000
5	Tax (40%)	$440,000	$360,000	$280,000
6	Net Income (4-5)	$660,000	$540,000	$420,000
7	Total Equity	$9,000,000	$7,000,000	$5,000,000
8	Price per share	$90	$90	$90
9	No. of Shares (7/8)	100,000	77,778	55,556
10	Earnings per share (6/9)	$6.60	$6.94	$7.56

Ans. (d)

Calculation of level of EBIT at the point of indifference:

EPS = (EBIT_current – Interest Exp.)*(1-t)

EPS = (EBIT_indifference – Interest Exp.)*(1-t)

Since we want to calculate the EBIT at the point of indifference (where the level of EBIT does not affect EPS)

(EBIT_current – Interest exp. At 30% Debt)*(1-t) = (EBIT_indifference –– Interest exp. At 30% Debt))*(1-t)

(EBIT_current – Interest exp. At 30% Debt) = (EBIT_indifference – Interest exp. At 50% Debt)

(EBIT_current – $300,000) = (EBIT_indifference – $500,000)

Therefore,

EBIT_{indifference =} EBIT_{current -} $200,000

EBIT_{indifference =} $,200,000 _- $200,000

₌ $1,000,000

Therefore level of EBIT at the point of indifference is $1,000,000.

It can also be demonstrated through following calculation:

Sl. No.		Option A (30% Debt)	Option B (50% Debt)
1	Expected EBIT	$1,000,000	$1,000,000
2	Total Debt	$3,000,000	$5,000,000
3	Expected Interest Exp. (10%)	$300,000	$500,000
4	Expected EBT (1-3)	$700,000	$500,000
5	Tax (40%)	$280,000	$200,000
6	Net Income (4-5)	$420,000	$300,000
7	Total Equity	$7,000,000	$5,000,000
8	Price per share	$90	$90
9	No. of Shares (7/8)	77,778	55,556
10	Earnisgs per share (6/9)	$5.40	$5.40