The Canterbury Coach Corporation has EBIT of $3.62 million and total capital of $20 million, which is 15% debt. The 425,000 shares of stock outstanding sell at book value. The firm pays 12% interest on its debt and is subject to a combined state and federal tax rate of 40%. Canterbury is contemplating a capital restructuring to either 30%, 45%, 60%, or 75% debt.
a. At the current level of profitability, will more debt enhance results? Why?
b. Calculate the EAT, ROE, EPS, and the DFL at the current and proposed structures, and display your results in a systematic table.
c. In a short paragraph referring to your table, discuss the trade-off between performance and increased risk (reflected in the DFL) as leverage increases. Do some levels seem to make more sense than others? What business characteristics would make the higher leverage levels less of a problem?