Company ABC expects next year’s operating earnings (EBIT) to be $2 million. Suppose it has total assets of $10 million and no debt. It currently has 1 million shares outstanding with a book value of $10 per share. It is planning a capital restructuring to achieve a debt-to-book equity ratio of 1. Based on yields on similar debt in the marketplace, the company estimates that it will have to pay 6% interest rate if it issues bonds. The income tax rate applicable to the company is 25%

(a) Before the capital restructuring: Calculate the company’s net income and return on equity, where return on equity is calculated as: Net income/shareholders’ equity. Determine the Degree of Financial Leverage (DFL) at an operating income of $2 million. What is the DFL if operating income is: $500,000 or $1 million? Explain and comment on the DFL and ROE observed across these 3 levels of EBIT.

(b) After the capital restructuring: Determine the Degree of Financial Leverage (DFL) at an operating income of $2 million. What is the ROE and DFL if operating income is: $500,000 or $1 million? Compare with the no leverage case and explain your observations.

(c) The company expects to produce 115,000 units and sell each unit at $100. Variable cost per unit is $80 and fixed operating cost is $300,000. Calculate the DOL at 115,000 units. Determine the number of units sold and the DOL if EBIT is $500,000.

(d) Calculate the degree of total leverage (DTL) at 115,000 units sold, based on your answers to parts (b) and (c).

Answer rating: 100% (QA)

a Before the capital restructuringCalculate the companys net income and return on equity where return on equity iscalculated as Net incomeshareholders ... View the full answer