KEY ISSUES
Tampa Manufacturing, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. n the basis of this scenario, the firm!s management has been instructed by its board to institute programs that will allo allow w it to oper operate ate more efficient efficiently ly,, earn higher prof profits its,, and, most imp importa ortant, nt, maximi"e share value. #n this regard, the firm!s chief financial officer $%&', (on )awson, has been charged with evaluating the firm!s capital structure. )awson believes that the current capital structure, which contains *+ debt and -+ equity, may lack adequate financial leverage. To To evaluate the firm! firm!ss capital structure, )awson has gathered the data summari"ed in the following table on the current capital structure $*+ debt ratio' and two alternative capit ca pital al st struc ructur tures es/ / $3 $3+ + deb debtt ra ratio tio'' and 0 $5+ $5+ deb debtt rat ratio io't 'that hat he wo would uld li like ke to consider.
Source of capital )ong1term debt %oupon interest rate %ommon stock 6equired return on equity
Current (10% debt) 2*,+++,+++ - *++,+++ shares *
A (30% debt) 23,+++,+++ * + 4+,+++ shares * 3
B (50% debt) 25,+++,+++ * +,+++ shares *7
These structures are based on maintaining the firm!s current level of 2*+,+++,+++ of total financing. )awson expects the firm!s earnings before interest and taxes $80#T' to remain at its current level of 2*,++,+++. The firm has a + tax rate.
e!uired" a# 9se the current level of 80#T to calculate the times interest earned ratio for each capital
structure. 8valuate the current and two alternative capital structures using the times interest earned and debt ratios.
:rep epare are a sin single gle 80 80#T #T;8 ;8:< :< gr graph aph sho showi wing ng the cu curre rrent nt an and d tw two o alt alter ernat native ive ca capit pital al b# :r structures. 1
c# n the basis of the graph in part b$ which capital structure will maximi"e Tampa!s earnings
per share $8:<' at its expected level of 80#T of 2*,++,+++= >hy might this not be the best capital structure=
d# 9sing the "ero1growth valuation model given in 8quation *.*, find the market value of
Tampa!s equity under each of the three capital structures at the 2*,++,+++ level of expected 80#T.
e# n the basis of your findings in parts c and d$ which capital structure would you
recommend= >hy=
AA&YSIS ' KEY ISSUES
2
Ke I**ue* (a)" 9se the current level of 80#T to calculate the times interest earned ratio for
each capital structure. 8valuate the current and two alternative capital structures using the times interest earned and debt ratios.
Anal*i*" Times interest earned calculations. Current 10% +ebt
Alternati,e A 30%
Alternati,e B 50%
+ebt
+ebt
?ebt
2*,+++,+++
23,+++,+++
25,+++,+++
%oupon rate
+.+-
+.*+
+.*
#nterest
2 -+,+++
2 3++,+++
2 @++,+++
80#T
2*,++,+++
2*,++,+++
2*,++,+++
#nterest
2 -+,+++
2 3++,+++
2 @++,+++
Times interest earned
*3.33
Co--ent"
/s the debt ratio increases from *+ to 5+, so do both financial leverage and risk. /t *+ debt and 2*,++,+++ 80#T, the firm has over *3 times coverage of interest paymentsA at 3+, it still has times coverage. /t 5+ debt, the highest financial leverage, coverage drops to times, which may not provide enough cushions. 0oth the times interest earned and debt ratios should be compared to those of the printing equipment industry.
Ke I**ue* (b)" :repare a single 80#T;8:< graph showing the current and two alternative
capital structures. EBI.
/00$000
/1$00$000
/00$000
/1$00$000
/00$000
#nterest
-+,+++
-+,+++
3++,+++
3++,+++
@++,+++
3
/1$00$000
@++,+++
80T
25*+,+++
2*,**+,+++
23++,+
2 -++,+++
2+
2 @++,+++
Taxes+
+,++
,+++
*+,+++
3@+,+++
+
+,+++
8/T
23+@,+++
2 @@@,++
2*7+,+++
2 5+,+++
2+
2 3@+,+++
8:<
2 3.+@
2 @.@@
2 .54
2 4.4*
+
2 -.++
Current 10% +ebt
Alternati,e A 30% +ebt
Alternati,e B 50% +ebt
100$000 S2are*
0$000 S2are*
40$000 S2are*
Anal*i*" 80#T18:< calculations $using any two 80#T levels'.
Co--ent"
>e see that the graph shows that 80#T in the B axis and 8:< in the C axis. >hen debt was *+ debt than 8:< was 2@.@@ and 3+ debt the 8:< 24.4* and when 5+ debt it shows 2-. Ke I**ue* (c)" n the basis of the graph in part b, which capital structure will maximi"e
Tampa!s earnings per share $8:<' at its expected level of 80#T of 2*,++,+++= >hy might this not be the best capital structure=
Anal*i*" #f Tampa Manufacturing!s 80#T is 2*,++,+++, 8:< is highest with the 5+ debt
ratio. The steeper slope of the lines representing higher debt levels demonstrates that financial leverage increases as the debt ratio increases. /lthough 8:< is highest at 5+, the company must also take into consideration the financial risk of each alternative. The drawback to the
4
80#T18:< approach is its emphasis on maximi"ing 8:< rather than owner!s wealth. #t does not take risk into account. /lso, if 80#T falls below about 245+,+++ $intersection of *+ and 3+ debt', 8:< is higher with a capital structure of *+.
Ke I**ue* (d)" 9sing the "ero1growth valuation model given in 8quation *.*, find the
market value of Tampa!s equity under each of the three capital structures at the 2*,++,+++ level of expected 80#T.
5
Anal*i*" ar6et ,alue"
P0= EPS ÷ r s
Current" /# 7 0#1 8 /55#50 Alternati,e A930%" /#1 7 0#13 8 /5:#31 Alternati,e B950%" /:#00 7 0#1; 8 /50#0
Ke I**ue* (e)" n the basis of your findings in parts c and d$ which capital structure would
you recommend= >hy=
Anal*i*" /lternative /, 3+ debt, appears to be the best alternative. /lthough 8:< is
higher with /lternative 0, the financial risk is highA times interest earned is only times. 6
/lternative / has a moderate risk level, with times coverage of interest earned, and provides increased market value. %hoosing this capital structure allows the firm to benefit from financial leverage while not taking on too much financial risk.
EC'E+A.I'
&rom the above calculation of Tampa Manufacturing %ompany!s debt ratio and time interest ratio given *3.33 times, times, and times when debt *+, 3+ and 5+ debt.
7
company and 8:< is satisfactory. Though 5+ debts is highest 8:< and maximi"e owner!s wealth.
C'C&USI'
Tampa Manufacturing %ompany!s chose current capital structure than it earns 8/T 2@, @@,+++ with 2@.@@ 8:< and chose alternative / capital structure than earns 25,+,+++ 8/T with 2 4.4* 8:< and alternative 0 capital structure than earns 23@++++ 8/T with 2- 8:<.
8
/lternative / also time coverage of interest earned and yester than /lternative 0. it also maximi"e the company!s wealth than /lternative 0.
EEECE
www.tompa.manufacturing.comD httpEDDusers.rowan.eduDFpritchardD++7+solutionsDGitmanH#MHch**.pdf :rinciples1of1Managerial1&inance1 tenth edition1by1Gitman 9
&undamentals of %orporate &inance,
>ho did what= I+
a-e
Slide
10
eport
+*5*++++73
Md. /riful #slam
√
co-paction* /nalysis
+*5*++++7
Ia"i
√
/nalysis
√
+*5*++++33
/rman Jossain Talukder
×
/nalysis
√
+**+++*+5
(oinob 0inte (ahan
×
/nalysis
√
+*5*++++75
9mmul (ahan (uthi
×
/nalysis
√
11
co-plete √
