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Solutions Guide: Please Reword The Answers To Essay Type Parts So As To Guarantee That Your Answer Is An Original. Do Not Submit As Your Own

Tower Interiors forecast three levels of annual sales with associated probabilities. It calculated earnings before interest and taxes for each sales level, then earnings per share both with and without debt. With debt, the expected EPS was $0.18 with a high coefficient of variation of 6.32, indicating high financial risk. Eliminating debt increased the expected EPS to $0.60 and lowered the coefficient of variation to 1.265, demonstrating that reducing leverage significantly decreased the company's financial risk.

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109 views3 pages

Solutions Guide: Please Reword The Answers To Essay Type Parts So As To Guarantee That Your Answer Is An Original. Do Not Submit As Your Own

Tower Interiors forecast three levels of annual sales with associated probabilities. It calculated earnings before interest and taxes for each sales level, then earnings per share both with and without debt. With debt, the expected EPS was $0.18 with a high coefficient of variation of 6.32, indicating high financial risk. Eliminating debt increased the expected EPS to $0.60 and lowered the coefficient of variation to 1.265, demonstrating that reducing leverage significantly decreased the company's financial risk.

Uploaded by

Tatiana Sanchez
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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Solutions Guide:  

Please reword the answers to essay type parts so as to guarantee


that your answer is an original. Do not submit as your own.

Towers interiors has made the forecast of sales shown in the following table. Also given
is the probability of each level of sales. Sales= $200,000/Probability=.20
Sales=$300,000/Probability=.60 Sales=$400,000/Probability=.20 The firm has fixed
operating costs of $75,000 and variable operating costs equal to 70%of the sales level.
The company pays $12,000 in interest per period. The tax rate is 40%. a. Compute the
earnings before interest and taxes (EBIT) for each level of sales. b. Compute the earnings
per share (EPS) for each level of sales, the expected EPS, the standard deviation of the
EPS, and the coefficient of variation of EPS, assuming that there are 10,000 shares of
common stock outstanding. c. Tower has the opportunity to reduce its leverage to zero
and pay no interest. This will require that the number of shares outstanding be increased
to 15,000. Repeat part b under this assumption. d. Compare your findings in parts b and
c, and comment on the effect of the reduction of debt to zero on the firm's financial risk.

(a) EBIT Calculation


Probability 0.20 0.60 0.20
Sales $200,000 $300,000 $400,000
Less: Variable costs (70%) 140,000 210,000 280,000
Less: Fixed costs 75,000 75,000 75,000
EBIT $(15,000) $15,000 $45,000
Less Interest 12,000 12,000 12,000
Earnings before taxes $(27,000) $3,000 $33,000
Less: Taxes (10,800) 1,200 13,200
Earnings after taxes $(16,200) $1,800 $19,800

(b) EPS
Earnings after taxes $(16,200) $1,800 $19,800
Number of shares 10,000 10,000 10,000
EPS $(1.62) $0.18 $1.98
n
Expected EPS   EPSj  Prj
i=1

Expected EPS  ($1.62  0.20)  ($0.18  0.60)  ($1.98  0.20)


Expected EPS  $0.324  $0.108  $0.396
Expected EPS  $0.18
n
 EPS   (EPS
i 1
i  EPS)2  Pri

 EPS  [($1.62  $0.18)2  0.20]  [($0.18  $0.18)2  0.60]  [($1.98  $0.18)2  0.20]
 EPS  ($3.24  0.20)  0  ($3.24  0.20)
 EPS  $0.648  $0.648
 EPS  $1.296  $1.138
 EPS 1.138
CVEPS    6.32
Expected EPS 0.18
(c)
EBIT * $(15,000) $15,000 $45,000
Less: Interest 0 0 0
Net profit before taxes $(15,000) $15,000 $45,000
Less: Taxes (6,000) 6,000 18,000
Net profits after taxes $(9,000) $9,000 $27,000
EPS (15,000 shares) $(0.60) $0.60 $1.80

*
 From part (a)

Expected EPS  ($0.60  0.20)  ($0.60  0.60)  ($1.80  0.20)  $0.60

 EPS  [( $0.60  $0.60)2  0.20]  [($0.60  $0.60)2  0.60]  [($1.80  $0.60)2  0.20]
 EPS  ($1.44  0.20)  0  ($1.44  0.20)
 EPS  $0.576  $0.759
$0.759
CVEPS   1.265
0.60
(d) Summary Statistics
With Debt All Equity
Expected EPS $0.180 $0.600
EPS $1.138 $0.759
CVEPS 6.320 1.265

Including debt in Tower Interiors’ capital structure results in a lower expected EPS, a
higher standard deviation, and a much higher coefficient of variation than the all-
equity structure. Eliminating debt from the firm’s capital structure greatly reduces
financial risk, which is measured by the coefficient of variation.

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