151 CHAPTER 15 Leverage and the Debt-Equity Mix

QUESTIONS
1. In what way is business levera e si!ilar t" #hysi$al levera e% Both types of leverage involve magnification. In both, we carefully construct our system to produce the magnified result. The differences are in what is magnifiedincome vs. physical force, and what serves as the leverfixed costs vs. a mechanical device. &. 'istin uish between "#eratin levera e an( )inan$ial levera e. Both operating and financial leverage result in the magnification of changes to earnings due to the presence of fixed costs in a company's cost structure. The difference is only the part of the income statement we are looking at. Operating leverage is the magnification on the top half of the income statementhow BIT changes in response to changes in sales! the relevant fixed cost is the fixed cost of operating the business. "inancial leverage is the magnification on the bottom half of the income statement how earnings per share changes in response to changes in BIT! the relevant fixed cost is the fixed cost of financing, in particular interest. *. H"w !u$h $h"i$e ("es a )ir! have "ver its "#eratin levera e% Over its )inan$ial levera e% #hoice over operating leverage depends on the technologies available to a company. $ome companies have little control over their operating leverage. "or example, airlineswhich have no substitute for airplanes and their associated support systemscan only operate with a large investment in fixed assets that create fixed costs. Other companies have a significant degree of control over their operating leverage. %any manufacturing companies, for example, can choose to produce using automated e&uipment or piecework labor. By contrast, most firms have total control over their financial leverage through their choice of financing 'the exception is small firms that have limited access to financial markets, hence limited financing alternatives(. ) company can increase its financial leverage by using debt financing and can avoid financial leverage through financing with e&uity. +. 'es$ribe the way in whi$h earnin s #er share res#"n(s t" $han in E,IT in a )ir! witha. N" )i.e( )inan$in $"sts. ) firm with no fixed financing costs has no financial leverage. In such a firm, earnings per share will rise and fall with BIT by the same percentage. "or example, a *+, increase in BIT will result in a *+, increase in -$! a ., decrease in BIT will result in a ., decrease in -$.

15&

Cha#ter 15

b. S"!e )i.e( )inan$in $"sts. ) firm with some fixed financing costs does have financial leverage. In such a firm, earnings per share will rise and fall with BIT by a greater percentage. "or example, a *+, increase in BIT will result in a more/than/*+, increase in -$! a ., decrease in BIT will result in a more/than/., decrease in -$. 5. H"w ("es a )ir!/s )inan$ial levera e a))e$t- "inancial leverage changes a firm's returns and risk. a. Its #r")itability% "inancial leverage changes a firm's earnings per share. To the left of the indifference point 'lower BIT( between financing alternatives 'refer to "igure *+.0, p. +11( financial leverage reduces -$. To the right of the indifference point 'greater BIT( -$ is increased as the firm takes on financial leverage. This observation indicates the importance of knowing the indifference point and where a company's level of BIT is relative to it. b. Its level ") ris0% "inancial leverage increases the volatility of a firm's earnings per share. )s a firm increases its financial leverage, its -$ will rise and fall by magnified amounts in response to changes in BIT. This makes the -$ stream riskier for investors. )lso, the possibility that -$ could be lower than if there were less financial leverage 'if BIT is left of the indifference point( and the power over the firm given to creditors should the firm have difficulty paying its debts create additional risks for shareholders. 1. A )ir! is $"nsi(erin tw" alternative $a#ital stru$tures2 an( has $al$ulate( its #r")itability at vari"us E,IT levels un(er ea$h stru$ture. 3hat sh"ul( the )ir! (" i) its #r"4e$te( E,IT isa. ,el"w the in(i))eren$e #"int% In this case, choose the capital structure with the lower degree of financial leverage. If BIT is below 'to the left of( the financing indifference point, higher financial leverage would decrease -$ 'lower return( as it increases the volatility of the -$ stream 'higher risk(. 2owever, lower financial leverage would increase -$ 'higher return( and decrease the volatility of the -$ stream 'lower risk(, the combination preferred by risk/averse investors. b. Ab"ve the in(i))eren$e #"int% In this case, the choice of capital structure is not obvious, since there is a tradeoff between the effects of financial leverage on risk and return. If BIT is above 'to the right of( the indifference point, higher financial leverage would increase -$ 'higher return( but also increase the volatility of the -$ stream 'higher risk(. 3ower financial leverage would decrease -$ 'lower return( and decrease the volatility of the -$ stream 'lower risk(. "urther analysis is re&uired to identify which capital structure provides investors with the best risk/return combination. 5. C"!#are an( $"ntrast the 6net in$"!e a##r"a$h27 6net "#eratin in$"!e a##r"a$h27 an( 6tra(iti"nal a##r"a$h7 t" the "#ti!al (ebt8e9uity !i.. 3hi$h assu!#ti"ns (" y"u )in( reas"nable% Unreas"nable% The net income approach, net operating income approach, and traditional approach are three theoretical frameworks for how a company should set its debt/e&uity mix. )ll three examine how a company's cost of capital changes with the debt/e&uity mix and search for the lowest value of the cost of capital, hence the maximum value of the firm, to identify the best mix. They reach different conclusions because they make different assumptions about creditors' and investors' reactions to increasing debt.

:evera e an( the 'ebt8E9uity ;i.

15*

ach of us will have our own feelings about the reasonableness of the assumptions. 4ithout going into the %odigliani/%iller mathematics, the assumptions of the traditional approach usually seem most reasonable to most people. '*( The net income approach makes the simplest assumptions, that neither creditors nor investors increase their re&uired rates of return as a company takes on debt. The cost of capital declines as higher/cost e&uity is replaced with lower/cost debt. This approach concludes that the optimal financing mix is all debt. '5( The net operating income approach assumes that creditors do not increase their re&uired rate of return as a company takes on debt, but investors do. "urther, the rate at which investors increase their re&uired rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive e&uity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mixany mix is as good as any other. '1( The traditional approach assumes that both creditors and investors increase their re&uired rates of return as a company takes on debt. )t first this increase is small, and the weighting toward lower/cost debt pushes the cost of capital down. ventually, the rate at which creditors and investors increase their re&uired rates of return accelerates and dominates the weighting toward debt, pushing the cost of capital back upward. The result is that the cost of capital declines with debt and reaches a minimum point before rising again. This approach concludes that there is a optimal financing mix consisting of some debt and some e&uity. <. 3hat r"le ("es ea$h ") ;;/s assu!#ti"ns #lay in their the"ry ") the (ebt8e9uity !i.% %%'s key assumptions and the role played by each are6 '*( 7nlimited borrowing and lending is available to all market participants at one rate of interest. 8ole6 makes the cost of personal and corporate borrowing and lending the same. '5( Individual margin borrowing is secured by the shares purchased, the borrower's liability is limited to the value of these shares, there are no costs to bankruptcy. 8ole6 makes the risk of personal and corporate borrowing and lending the same. '1( )ll companies can be grouped into e&uivalent risk classes. 8ole6 enables investors to identify companies with identical business risk. '0( #apital markets are perfect. 8ole6 permits investors to easily and costlessly arbitrage between securities of companies which differ only in their financing mix. '+( There are no corporate income taxes. 8ole6 prevents the tax code from making debt financing more valuable by allowing interest and not dividends as a tax deduction. '9( $hareholders are indifferent to the form of their returns, all returns are taxed at the same rate. 8ole6 prevents investors from seeing any difference in value between interest, dividends, and capital gains. =. 'es$ribe 6h"!e!a(e levera e.7 2omemade leverage is investors' method of substituting their own borrowing or lending for corporate borrowing. Investors who want more leverage than a company has taken on can buy the company's stock on marginthat is, borrow money from a broker and use the borrowed funds to pay for a portion of the stock in order to add

15+

Cha#ter 15

to the corporate borrowing. Investors who want less leverage than the company has taken on can invest a portion of their funds in a risk/free investment to offset some of the corporate borrowing. %% argued that homemade leverage was a perfect substitute for corporate borrowing, given their assumptions. )s a result, investors do not care how much debt any firm has since they can use homemade leverage to ad:ust their overall debt exposure to precisely reproduce the effect of any level of corporate debt on their returns and risk. 1>. Is Pr")ess"r ;iller/s #ers"nal ta. !"(el relevant in t"(ay/s ta. envir"n!ent% %iller's personal tax model examined the effect of personal income taxes on the debt/e&uity mix decision. 2e observed that personal income taxes in the 7.$. favor e&uity financing since profits from e&uity investments come primarily in the form of capital gains which are taxed later and at potentially lower rates than interest income from debt investments. %iller determined that the bias in personal income taxes toward e&uity essentially offset the bias toward debt in the corporate income tax code and concluded that this supported the original %% conclusion that the financing mix is irrelevant to a company's value. $ince the time %iller wrote, the difference between the tax rates on ordinary income and capital gains has narrowed, somewhat weakening his argument. 4ith today's personal tax rate structure, it is likely that the bias toward debt from the corporate income tax dominates the favoring of e&uity by personal taxes. 2owever, some politicians continue to advocate for further reductions in capital gains tax rates! if this happens, we will once again move closer to %iller's conclusions. 11. 3hat are the variables that enter $"!#r"!ise the"ry% 3hat is the e))e$t ") ea$h "n the "#ti!al (ebt8e9uity !i.% In compromise theory, the value of a levered firm e&uals the value of the same firm without leverage modified by the impact of three factors6 '*( #orporate income taxes the bias toward debt in the corporate income tax code adds value to companies with debt financing. '5( Bankruptcy costs the increased probability of loss should a company be unable to service its debt subtracts value from companies with debt financing. '1( )gency costs the increased difficulty of aligning management actions with shareholder needs in a company with debt subtracts value from companies with debt financing. 1&. 'e)ine the !eanin ") ea$h letter ") 6?RICTO27 an( ive an illustrati"n ") ea$h. "8I#TO is an acronym summari;ing important issues that affect the debt/e&uity mix decision in practice6 '*( " < flexibility the impact of alternative financing choices on the firm's future ability to raise funds in any form re&uired. ) company with flexibility will not be shut out of the financial markets nor forced to take a type of financing that is not its preferred choice. '5( 8 < risk the impact of alternative financing choices on the risks faced by the firm and its stakeholders. In general, taking on additional debt adds to the risks of creditors and shareholders. '1( I < income the impact of alternative financing choices on the firm's income stream. ) firm with BIT above the financing indifference point that increases its debt will increase its earnings per share.

:evera e an( the 'ebt8E9uity ;i.

155

'0( # < control the impact of alternative financing choices on each shareholder's amount of control of the firm. In general, selling additional shares of common e&uity will dilute each shareholder's control. '+( T < timing the impact of market conditions on alternative financing choices. "inancial market conditions often favor one or another kind of financing. '9( O < other the impact of alternative financing choice on other issues and vice versa. )n example is the ability to use collateral to reduce the cost and risks of debt financing. 1*. 3hat is !eant by the 6#e$0in "r(er a##r"a$h7% @ive three e.#lanati"ns why it is an "bserve( #hen"!en"n. The pecking order approach is a se&uence of raising financing that many companies seem to follow, even though it ignores the recommendations of the various debt/e&uity/mix theories. The approach is to finance first with retained earnings, second with payables and bank debt, third with bonds and other more complex debt, and fourth with common stock issues. Three explanations for the pecking order approach are6 '*( It is the easiest way for financial managers to obtain funds since it re&uires the least amount of work and limits the need for potentially complex negotiations. '5( It raises funds in the order of low to high flotation costs, keeping these costs to a minimum. '1( The financial markets often take the announcement of a stock sale as negative information, assuming that management would only sell new shares if its share price were high, hence the stock was overvalued. 4hen management announces a stock sale, it signals this previously inside information 'asymmetric information( to the markets. By putting stock sales last on the list, the financial manager minimi;es the possibility of this reduction in the firm's share price taking place.

PRO,:E;S
SO:UTION PRO,:E; 151 'a( #onstruct an income statement $ales =+,>>>,>>> ?ariable costs 5,5+>,>>> 0+, of =+ million

151
#ontribution "ixed costs BIT Interest BT Taxes )T Ashares -$ 5,@+>,>>> *,>>>,>>> *,@+>,>>> > *,@+>,>>> 9*5,+>> *,*1@,+>> *,>>>,>>> =*.*0

Cha#ter 15

1+, of =*,@+>,>>>

"rom the statement6 BIT < =*,@+>,>>> -$ < =*.*0 'b( 8edo the income statement $ales up +, $ales =+,5+>,>>> ?ariable costs 5,195,+>> #ontribution 5,BB@,+>> "ixed costs *,>>>,>>> BIT *,BB@,+>> Interest > BT *,BB@,+>> Taxes 99>,95+ )T *,559,B@+ Ashares *,>>>,>>> -$ =*.51 "rom the statements6 BIT < =*,BB@,+>> -$ < =*.51 $ales down +, =0,@+>,>>> 5,*1@,+>> 5,9*5,+>> *,>>>,>>> *,9*5,+>> > *,9*5,+>> +90,1@+ *,>0B,*5+ *,>>>,>>> =*.>+ =*,9*5,+>> =*.>+

0+, no change

1+,

'c( "or sales up by +,6 BIT went from =*,@+>,>>> to =*,BB@,+>>, an increase of *,BB@,+>> *,@+>,>>> < @.B9, *,@+>,>>> -$ went from =*.*0 to =*.51, an increase of =*.51 *.*0 < @.B., *.*0

:evera e an( the 'ebt8E9uity ;i.

"or sales down by +,6 BIT went from =*,@+>,>>> to =*,9*5,+>>, a decrease of *,9*5,+>> *,@+>,>>> < @.B9, *,@+>,>>> -$ went from =*.*0 to =*.>+, a decrease of =*.>+ *.*0 < @.B., *.*0

155

'd( In all cases, BIT and -$ change by the same percentage 'within round/off error(. Observe the following6 '*( $ince this company has fixed operating costs, it has operating leverage. BIT changes by more than sales '@.B9, vs. +,(. '5( $ince this company has no fixed financing costs 'no interest(, it has no financial leverage. -$ changes by the same percentage as BIT. '1( 3everage is symmetricalthe changes are the same regardless of whether sales is increasing or decreasing.

SO:UTION PRO,:E; 15& 'a( #onstruct an income statement $ales =+,>>>,>>> ?ariable costs 1,5+>,>>> #ontribution *,@+>,>>> "ixed costs > BIT *,@+>,>>> Interest @+>,>>> BT *,>>>,>>> 9+, of =+ million

15<
Taxes )T Ashares -$ 1+>,>>> 9+>,>>> *,>>>,>>> =>.9+ 1+, of =* million

Cha#ter 15

"rom the statement6 BIT < =*,@+>,>>> -$ < =>.9+ 'b( 8edo the income statement $ales up +, $ales =+,5+>,>>> ?ariable costs 1,0*5,+>> #ontribution *,B1@,+>> "ixed costs > BIT *,B1@,+>> Interest @+>,>>> BT *,>B@,+>> Taxes 1B>,95+ )T @>9,B@+ Ashares *,>>>,>>> -$ =>.@* "rom the statements6 BIT < =*,B1@,+>> -$ < =>.@* $ales down +, =0,@+>,>>> 1,>B@,+>> *,995,+>> > *,995,+>> @+>,>>> .*5,+>> 1*.,1@+ +.1,*5+ *,>>>,>>> =>.+. =*,995,+>> =>.+.

9+, still >

1+,

'c( "or sales up by +,6 BIT went from =*,@+>,>>> to =*,B1@,+>>, an increase of *,B1@,+>> *,@+>,>>> < +.>>, *,@+>,>>> -$ went from =>.9+ to =>.@*, an increase of =>.@* >.9+ < ..51, >.9+ "or sales down by +,6 BIT went from =*,@+>,>>> to =*,995,+>>, a decrease of *,995,+>> *,@+>,>>> < +.>>, *,@+>,>>> -$ went from =>.9+ to =>.+., a decrease of =>.+. >.9+ < ..51,

:evera e an( the 'ebt8E9uity ;i.

>.9+

15=

'd( -$ changes by more than BIT in both cases. Observe the following6 '*( $ince this company has no fixed operating costs, it has no operating leverage. BIT changes by the same percentage as sales 'both by +.>>,(. '5( $ince this company has fixed financing costs 'interest(, it has financial leverage. -$ changes by a greater percentage than BIT '..51, vs. +.>>,(. '1( 3everage is symmetricalthe changes are the same regardless of whether sales is increasing or decreasing. SO:UTION PRO,:E; 15* 'a( BIT Interest BT Taxes )T Ashares -$ )lternative A* *,>>>,>>> 5+>,>>> @+>,>>> 595,+>> 0B@,+>> 5>>,>>> =5.00 )lternative A5 *,>>>,>>> 1+>,>>> 9+>,>>> 55@,+>> 055,+>> *+>,>>> =5.B5

1+,

'b( BIT Interest BT Taxes )T Ashares -$ 'c( BIT Interest BT

)lternative A* *,*>>,>>> 5+>,>>> B+>,>>> 5.@,+>> ++5,+>> 5>>,>>> =5.@9 )lternative A* .>>,>>> 5+>,>>> 9+>,>>>

)lternative A5 *,*>>,>>> 1+>,>>> @+>,>>> 595,+>> 0B@,+>> *+>,>>> =1.5+ )lternative A5 .>>,>>> 1+>,>>> ++>,>>>

1+,

151>
Taxes )T Ashares -$ 55@,+>> 055,+>> 5>>,>>> =5.** *.5,+>> 1+@,+>> *+>,>>> =5.1B 1+,

Cha#ter 15

'd( )lternative A5 has the greater amount of leverage since it has higher fixed costs 'interest(. In these examples, BIT is high enough so that )lternative A5 provides the greater amount of -$, hence the higher returns. But alternative A5 also has the higher level of risk. 7nder )lternative A*, -$ swings from =5.00 down to =5.**' *1.+5,( and up to =5.@9'C*1.**,(. 7nder )lternative A5, -$ swings from =5.B5 down to =5.1B' *+.9>,( and up to =1.5+'C*+.5+,(, a greater range in percentage terms. There is a tradeoff here between returns and risk. SO:UTION PRO,:E; 15+ 'a( BIT Interest BT Taxes )T Ashares -$ )lternative A* B,>>>,>>> 5,5+>,>>> +,@+>,>>> 5,>*5,+>> 1,@1@,+>> *,>>>,>>> =1.@0 )lternative A5 B,>>>,>>> 0,>>>,>>> 0,>>>,>>> *,0>>,>>> 5,9>>,>>> B>>,>>> =1.5+

1+,

'b( BIT Interest BT Taxes )T Ashares -$ 'c( BIT Interest BT Taxes

)lternative A* .,5>>,>>> 5,5+>,>>> 9,.+>,>>> 5,015,+>> 0,+*@,+>> *,>>>,>>> =0.+5 )lternative A* 9,B>>,>>> 5,5+>,>>> 0,++>,>>> *,+.5,+>>

)lternative A5 .,5>>,>>> 0,>>>,>>> +,5>>,>>> *,B5>,>>> 1,1B>,>>> B>>,>>> =0.51 )lternative A5 9,B>>,>>> 0,>>>,>>> 5,B>>,>>> .B>,>>>

1+,

1+,

:evera e an( the 'ebt8E9uity ;i.

)T Ashares -$ 5,.+@,+>> *,>>>,>>> =5..9 *,B5>,>>> B>>,>>> =5.5B

1511

'd( )lternative A5 has the greater amount of leverage since it has higher fixed costs 'interest(. In this example, however, BIT is not high enough for )lternative A5 to provide the greater returns)lternative A5 has lower returns 'lower -$( than )lternative A*. )lso, )lternative A5 has the higher level of risk. 7nder )lternative A*, -$ swings from =1.@0 down to =5..9'5>.B9,( and up to =0.+5'C5>.B9,(. 7nder )lternative A5, -$ swings from =1.5+ down to =5.5B'5..B+,( and up to =0.51'C1>.*+,(, a greater range in percentage terms. )lternative A* is clearly preferable to )lternative A5. SO:UTION PRO,:E; 155 'a( Try a couple of values for BIT and calculate -lan )6 BIT < =+>>,>>> -$ BIT < =1,>>>,>>> -$ -lan B6 BIT < =B>>,>>> -$ BIT < =1,>>>,>>> -$ -$ for each6 < => < =0.>9 < => < =+.@5

-lot these points and :oin them with a straight line6

-$ '=( 9 + 0 1 5 * * *,1>>,>>> 5 1 BIT '=million( ) B

'b(

' BIT i)('*t( < ' BIT iB('*t( $hares) $haresB ' BIT +>>,>>>('*.1+( < ' BIT B>>,>>>('*.1+(

151&
0>>,>>> 5+>,>>>

Cha#ter 15

0>>,>>>' BIT B>>,>>>( < 5+>,>>>' BIT +>>,>>>( 0>>,>>> BIT 15>,>>>,>>>,>>> < 5+>,>>> BIT *5+,>>>,>>>,>>> *+>,>>> BIT < *.+,>>>,>>>,>>> BIT < *,1>>,>>> 'c( -$ < ' BIT i('*t( Ashares

7se either alternative, since -$ is the same at this level of BIT. 7sing )lternative )6 -$ < '*,1>>,>>> +>>,>>>('*.1+( < B>>,>>>'.9+( < =*.1> 0>>,>>> 0>>,>>>

'd( 3ooking at the graph, -$ is higher6 -lan ) / left of break/even, i.e., for BIT D =*,1>>,>>> -lan B / right of break/even, i.e., for BIT E =*,1>>,>>>

SO:UTION PRO,:E; 151 'a( Try a couple of values for BIT and calculate -lan F6 BIT < =5,>>>,>>> -$ BIT < =9,>>>,>>> -$ -lan G6 BIT < =*,5>>,>>> -$ BIT < =9,>>>,>>> -$ -$ for each6 < => < =*>.0> < => < =9..1

-lot these points and :oin them with a straight line6

:evera e an( the 'ebt8E9uity ;i.

-$ '=( *5 *> B 9 0 5 * 5 1 1,>>>,>>> 0 + 9 BIT '=million( G

151*

'b(

' BIT iF('*t( $haresF

<

' BIT iG('*t( $haresG ' BIT *,5>>,>>>('*.1+( 0+>,>>>

' BIT 5,>>>,>>>('*.1+( < 5+>,>>>

5+>,>>> BIT 1>>,>>>,>>>,>>> < 0+>,>>> BIT .>>,>>>,>>>,>>> 5>>,>>> BIT < 9>>,>>>,>>>,>>> BIT < 1,>>>,>>> 'c( -$ < ' BIT i('*t( Ashares

7se either plan, since -$ is the same at this level of BIT. 7sing -lan F6 '1,>>>,>>> 5,>>>,>>>('*.1+( < *,>>>,>>>'.9+( < =5.9> 5+>,>>> 5+>,>>> 'd( 3ooking at the graph, -$ is higher6 -lan F / right of break/even, i.e., for BIT E =1,>>>,>>> -lan G / left of break/even, i.e., for BIT D =1,>>>,>>> -$ < SO:UTION PRO,:E; 155 'a( The optimal debt/e&uity mix is the one which minimi;es the cost of capital. 'b( Hebt -ercent #ost of -ercent #ost of #ost of

151+
ratio >, *> 5> 1> 0> +> 9> @> B> debt >, *> 5> 1> 0> +> 9> @> B> I debt 0.>, 0.> 0.> 0.5 0.+ 0.. +.0 9.5 @.+ C e&uity *>>, .> B> @> 9> +> 0> 1> 5> I e&uity *>.+, **.> **.9 *5.0 *1.9 *+.1 *@.B 5*.+ 59.> < capital *>.+>, *>.1> *>.>B ...0 ...9 *>.*> *>.19 *>.@. **.5>

Cha#ter 15

'c( The optimal mix is 1>, debt and @>, e&uity. )t this mix, the cost of capital reaches its minimum value of ...0,. 'd( The traditionalists argue that both debt and e&uity investors increase their re&uired rates of return as the firm takes on more debt due to the increasing risk they must bear. The change is slow at first, as a small amount of debt does not cause much risk, but re&uired rates rise more rapidly as the mix continues to move toward more debt.

SO:UTION PRO,:E; 15< 'a( Hebt ratio >, *> 5> 1> 0> +> -ercent #ost of -ercent #ost of #ost of debt I debt C e&uity I e&uity < capital >, 1.+, *>>, ..>, ..>>, *> 1.+ .> ..> B.0+ 5> 1.+ B> ..5 B.>9 1> 1.+ @> ..9 @.@@ 0> 1.@ 9> *>.5 @.9> +> 0.> +> **.0 @.@>

:evera e an( the 'ebt8E9uity ;i.

'b( The optimal mix is 0>, debt and 9>, e&uity. )t this mix, the cost of capital reaches its minimum value of @.9>,. 9> @> B> 9> @> B> 0.+ +.5 9.5 0> 1> 5> *1.> *+.5 *B.5 @..> B.5> B.9> 'c( Hebt ratio >, *> 5> 1> 0> +> 9> @> B> #ost of debt Increase 1.+, > 1.+ > 1.+ > 1.+ >.5, 1.@ >.1, 0.> >.+, 0.+ >.@, +.5 *.>, 9.5 #ost of e&uity Increase ..>, > ..> >.5, ..5 >.0, ..9 >.9, *>.5 *.5, **.0 *.9, *1.> 5.5, *+.5 1.>, *B.5

1515

The pattern is the same for both debt and e&uity. $mall increases in the debt ratio do not change creditors' nor stockholders' re&uired returns. 3arger debt ratios raise re&uired returns, and by an accelerating rate. $tockholders' re&uired rate of return rises faster than creditors' as they bear more risk.

'd( Hebt ratio >, *> 5> 1>

#ost of e&uity ..>, ..> ..5 ..9

#ost of debt < Hifference 1.+, +.+, 1.+ +.+ 1.+ +.@ 1.+ 9.*

1511
0> +> 9> @> B> *>.5 **.0 *1.> *+.5 *B.5 1.@ 0.> 0.+ +.5 9.5 9.+ @.0 B.+ *>.> *5.>

Cha#ter 15

These differences confirm the observations of part 'c(. The cost of e&uity rises at a faster rate than the cost of debt due to the greater risk assumed by stockholders. SO:UTION PRO,:E; 15= 'a( The compromise theory relationship is6 ?3 ? 8 H < ?7J3 ? 8 H C #T B# )# < ?3 ? 8 H 1+,>>> 1+,B>> 1+,9>> 1+,1>> 11,.>> 1*,0>> 5@,B>> 51,*>> *@,1>> 'b( The optimal mix is *>, debt and .>, e&uity. )t this mix, the value of the firm reaches its highest 'optimal( value of =1+,B>>,>>>. 'c( The Kacceptable rangeK appears to be from a little over >, debt through about 1>, debt. In this region, the firm's value seems to hold close to =1+.+ million. 'd( The corporate tax numbers '#T( increase at a constant rate with the debt ratio since they are related to it in a linear fashion. %ore debt more interest more tax deductions more present value of tax benefits. The bankruptcy cost 'B#( and agency cost ')#( numbers, on the other hand, reflect increasing risk perceptions which grow at an accelerating rate as the debt ratio increases. SO:UTION PRO,:E; 151> Hebt ratio >, *> 5> 1> 0> +> 9> @> B> ?7J3 ? 8 H C #T B# 1+,>>> > > *,>>> > 5,>>> *,>>> 1,>>> 5,>>> 0,>>> 0,>>> +,>>> @,>>> 9,>>> **,>>> @,>>> *9,>>> B,>>> 55,>>> )# > 5>> 0>> @>> *,*>> *,9>> 5,5>> 5,.>> 1,@>>

:evera e an( the 'ebt8E9uity ;i.

1515

'a( The compromise theory relationship is6 ?3 ? 8 H < ?7J3 ? 8 H C #T B# )# < ?3 ? 8 H > B>,>>> > B5,>>> > B0,+>> 0,>>> B5,B>> B,>>> B>,.>> *0,>>> @9,B>> 55,>>> @>,+>> 15,>>> 95,>>> 00,>>> +*,1>> 'b( The optimal mix is 5>, debt and B>, e&uity. )t this mix, the value of the firm reaches its highest 'optimal( value of =B0,+>>,>>>. 'c( The Kacceptable rangeK appears to be a narrow band around 5>, debt. )t debt ratios away from 5>,, the firm's value drops off rapidly. 'd( )gency costs arise with the very first dollar of debt since a new stakeholder has been added to the company. %anagement must integrateLalign the creditors with other stakeholder needs, creating a potential for loss of value by shareholders. Bankruptcy costs, on the other hand, only begin when the amount of debt grows large enough to pose default risks. SO:UTION PRO,:E; 1511 'a( Hebt ratio Jow < )fter 1,>>>,>>> < 1>, *>,>>>,>>> < 1,>>>,>>> C 5,>>>,>>> *>,>>>,>>> Hebt ratio >, *> 5> 1> 0> +> 9> @> B> ?7J3 ? 8 H C #T B>,>>> > 1,>>> 9,>>> .,>>> *5,>>> *+,>>> *B,>>> 5*,>>> 50,>>> B# )# > *,>>> *,+>> 5,5>> 1,*>> 0,5>> +,+>> @,>>> B,@>>

< +>,

'b( There would be =+,>>>,>>> of debt after the change6 )mount 1,>>>,>>> 5,>>>,>>> -roportion 9>, 0>, #ost +, 9.+, -roportion #ost 1.>>, 5.9>

151<
+.9>, 'c( Jow6 Hebt &uity )fter6 Hebt &uity -roportion 1>, @>, +>, +>, #ost +, *5, +.9, *0.>, -roportion #ost *.+>, B.0> ...>, 5.B>, @.>> ..B>,

Cha#ter 15

'd( Other things e&ual, yes / alter the debt/e&uity mix. This will reduce the cost of capital and increase the value of the firm. SO:UTION PRO,:E; 151& 'a( Hebt ratio Jow < 0>,>>>,>>> +>,>>>,>>> )fter 'b( #ost of #apital Jow6 Hebt &uity )fter6 Hebt &uity -roportion B>, 5>, #ost *>, *., -roportion #ost B.>>, 1.B> **.B>, +.>>, 9.>> **.>>, < B>,

< 0>,>>>,>>> *+,>>>,>>> < +>, +>,>>>,>>>

+>, +>,

*>, *5,

'c( 8efunding the *>, debt6 Hebt &uity +>, +>, 9, *5, 1.>>, 9.>> ..>>,

:evera e an( the 'ebt8E9uity ;i.

151=

'd( Ges / alter the mix and refund the expensive debt. The combined refinancing reduces the cost of capital from **.B>, to .,, significantly increasing the value of the firm.

15,1 APPEN'IA 15, Measuring the Degree of Leverage

PRO,:E;S
SO:UTION PRO,:E; 15,1 #onstruct the top lines of the company's income statement6 $ales ?ariable cost #ontribution =1>>,>>> *5>,>>> 0>, of sales *B>,>>> '* v( < 9>, of sales

Jow continue down the income statement for each case6 'a( " < => #ontribution "ixed cost BIT 'b( " < =0>,>>> #ontribution "ixed cost BIT 'c( " < =B>,>>> #ontribution "ixed cost BIT 'd( " < =*5>,>>> #ontribution "ixed cost BIT *B>,>>> > =*B>,>>> *B>,>>> 0>,>>> =*0>,>>> *B>,>>> B>,>>> =*>>,>>> *B>,>>> *5>,>>> = 9>,>>>

15,&
SO:UTION PRO,:E; 15,& #onstruct the top lines of the company's income statement6 $ales ?ariable cost #ontribution =*,@+>,>>> *,*1@,+>> 9*5,+>> 9+, of sales '* v( < 1+, of sales

A##en(i. 15,

Jow continue down the income statement for each case6 'a( " < => #ontribution "ixed cost BIT 'b( " < =*+>,>>> #ontribution "ixed cost BIT 'c( " < =1>>,>>> #ontribution "ixed cost BIT 'd( " < =0+>,>>> #ontribution "ixed cost BIT 9*5,+>> > =9*5,+>> 9*5,+>> *+>,>>> =095,+>> 9*5,+>> 1>>,>>> =1*5,+>> 9*5,+>> 0+>,>>> =*95,+>>

SO:UTION PRO,:E; 15,*

;easurin the 'e ree ") :evera e

8edo the income statements of problem *+B* with sales of =0>>,>>>6 $ales ?ariable cost #ontribution "ixed cost BIT BIT was 'a( =0>>,>>> *9>,>>> 50>,>>> > =50>,>>> *B>,>>> 'b( =0>>,>>> *9>,>>> 50>,>>> 0>,>>> =5>>,>>> *0>,>>> = 9>,>>> 'c( =0>>,>>> *9>,>>> 50>,>>> B>,>>> =*9>,>>> *>>,>>> = 9>,>>> 'd( =0>>,>>> *9>,>>> 50>,>>> *5>,>>> =*5>,>>> 9>,>>> = 9>,>>>

15,*

#hange to BIT = 9>,>>>

%easured in absolute dollars, BIT increases by =9>,>>> in all four cases.

Jote 6 0>, of sales, from problem *+B*

-ercentage change to BIT 'a( =9>,>>>L=*B>,>>> 'b( =9>,>>>L=*0>,>>> 'c( =9>,>>>L=*>>,>>> 'd( =9>,>>>L=9>,>>>

< 11.11, < 05.B9, < 9>.>>, < *>>.>>,

Jote6

greater percentage change with higher fixed costs.

SO:UTION PRO,:E; 15,+ 8edo the income statements of problem *+B5 with sales of =5,>>>,>>>6 $ales ?ariable cost #ontribution "ixed cost BIT BIT was #hange to BIT = 'a( =5,>>>,>>> *,1>>,>>> @>>,>>> > = @>>,>>> 9*5,+>> B@,+>> = 'b( =5,>>>,>>> *,1>>,>>> @>>,>>> *+>,>>> = ++>,>>> 095,+>> B@,+>> = 'c( =5,>>>,>>> *,1>>,>>> @>>,>>> 1>>,>>> = 0>>,>>> 1*5,+>> B@,+>> = 'd( =5,>>>,>>> *,1>>,>>> @>>,>>> 0+>,>>> = 5+>,>>> *95,+>> B@,+>>

%easured in absolute dollars, BIT increases by =B@,+>> in all four cases.

Jote 6 9+, of sales, from problem *+B5

15,+
-ercentage change to BIT 'a( =B@,+>>L=9*5,+>> 'b( =B@,+>>L=095,+>> 'c( =B@,+>>L=1*5,+>> 'd( =B@,+>>L=*95,+>>

A##en(i. 15,

< < < <

*0.5., *B..5, 5B.>>, +1.B+,

Jote6

greater percentage change with higher fixed costs.

SO:UTION PRO,:E; 15,5 '*( #onstruct income statements for each sales level6 $ales ?ariable cost #ontribution "ixed cost BIT 'a( =@>>,>>> 1+>,>>> 1+>,>>> 1>>,>>> = +>,>>> 'b( =B>>,>>> 0>>,>>> 0>>,>>> 1>>,>>> =*>>,>>> 'c( =.>>,>>> 0+>,>>> 0+>,>>> 1>>,>>> =*+>,>>> 'd( =*,>>>,>>> +>>,>>> +>>,>>> 1>>,>>> = 5>>,>>>

'5( Increase each sales number by *>, and construct new income statements6 $ales ?ariable cost #ontribution "ixed cost BIT 'a( =@@>,>>> 1B+,>>> 1B+,>>> 1>>,>>> = B+,>>> 'b( =BB>,>>> 00>,>>> 00>,>>> 1>>,>>> =*0>,>>> 'c( =..>,>>> 0.+,>>> 0.+,>>> 1>>,>>> =*.+,>>> 'd( =*,*>>,>>> ++>,>>> ++>,>>> 1>>,>>> = 5+>,>>>

Jote 6 +>, of sales

'1( #ompare BIT levels6 'a( #hange < =B+,>>> =+>,>>> < =1+,>>> -ercentage change < =1+,>>> < @>.>>, =+>,>>> 'b( #hange < =*0>,>>> =*>>,>>> -ercentage change < =0>,>>> =*>>,>>> 'c( #hange < =*.+,>>> =*+>,>>> -ercentage change < =0+,>>> =*+>,>>> < =0>,>>> < 0>.>>, < =0+,>>> < 1>.>>,

'd( #hange < =5+>,>>> =5>>,>>> < =+>,>>>

;easurin the 'e ree ") :evera e

-ercentage change < =+>,>>> =5>>,>>> < 5+.>>,

15,5

4hile the absolute change increases as sales goes up, the percentage change decreases as the firm's BIT rises. SO:UTION PRO,:E; 15,1 '*( #onstruct income statements for each sales level6 $ales ?ariable cost #ontribution "ixed cost BIT 'a( =5+>,>>> *>>,>>> *+>,>>> *5>,>>> = 1>,>>> 'b( =1>>,>>> *5>,>>> *B>,>>> *5>,>>> = 9>,>>> 'c( =1+>,>>> *0>,>>> 5*>,>>> *5>,>>> = .>,>>> 'd( =0>>,>>> *9>,>>> 50>,>>> *5>,>>> =*5>,>>>

'5( Increase each sales number by 5+, and construct new income statements6 $ales ?ariable cost #ontribution "ixed cost BIT 'a( =1*5,+>> *5+,>>> *B@,+>> *5>,>>> = 9@,+>> 'b( =1@+,>>> *+>,>>> 55+,>>> *5>,>>> =*>+,>>> 'c( =01@,+>> *@+,>>> 595,+>> *5>,>>> =*05,+>> 'd( =+>>,>>> 5>>,>>> 1>>,>>> *5>,>>> =*B>,>>>

Jote 6 0>, of sales

'1( #ompare BIT levels6 'a( #hange < =9@,+>> =1>,>>> < =1@,+>> -ercentage change < =1@,+>> < *5+.>>, =1>,>>>

'b( #hange < =*>+,>>> =9>,>>> -ercentage change < =0+,>>> =9>,>>> 'c( #hange < =*05,+>> =.>,>>> -ercentage change < =+5,+>> =.>,>>>

< =0+,>>> < @+.>>, < =+5,+>> < +B.11,

15,1

A##en(i. 15,

'd( #hange < =*B>,>>> =*5>,>>> < =9>,>>> -ercentage change < =9>,>>> < +>.>>, =*5>,>>> 4hile the absolute change increases as sales goes up, the percentage change decreases as the firm's BIT increases. SO:UTION PRO,:E; 15,5 HO3 < contribution BIT "rom problem *+B*6 'a( HO3 < =*B>,>>> =*B>,>>> 'b( HO3 < =*B>,>>> =*0>,>>> 'c( HO3 < =*B>,>>> =*>>,>>> 'd( HO3 < =*B>,>>> = 9>,>>> < * 4ith no fixed operating costs, HO3 always < *

< *.5. )s fixed operating costs rise, BIT declines < *.B> relative to contribution, and HO3 rises. < 1.>>

In problem *+B1, sales increased to =0>>,>>> 'from =1>>,>>> in problem *+B*(, a 11.11, increase. )pplying the HO3 numbers from above to the 11.11, change in sales gives the percentage change in BIT in problem *+B16 'a( 11.11,'*( < 11.11, 'b( 11.11,'*.5.( < 01.>>,, within roundoff of 05.B9, 'c( 11.11,'*.B>( < 9>.>>, 'd( 11.11,'1.>>( < *>>.>>, SO:UTION PRO,:E; 15,< HO3 < contribution BIT "rom problem *+B56 'a( HO3 < =9*5,+>> < * 4ith no fixed operating costs, HO3 always < *

;easurin the 'e ree ") :evera e

=9*5,+>> 'b( HO3 < =9*5,+>> =095,+>> 'c( HO3 < =9*5,+>> =1*5,+>> 'd( HO3 < =9*5,+>> =*95,+>>

15,5

< *.15 )s fixed operating costs rise, BIT declines < *..9 relative to contribution, and HO3 rises. < 1.@@

In problem *+B0, sales increased to =5,>>>,>>> 'from =*,@+>,>>> in problem *+B5(, a *0.5., increase. )pplying the HO3 numbers from above to the *0.5., change in sales gives the percentage change in BIT in problem *+B06 'a( *0.5.,'*( < *0.5., 'b( *0.5.,'*.15( < *B.B9,, 'c( *0.5.,'*..9( < 5B.>*, within roundoff error 'd( *0.5.,'1.@@( < +1.B@, SO:UTION PRO,:E; 15,= HO3 < contribution BIT -rior to the sales increase6 'a( HO3 < =1+>,>>> = +>,>>> 'b( HO3 < =0>>,>>> =*>>,>>> 'c( HO3 < =0+>,>>> =*+>,>>> 'd( HO3 < =+>>,>>> =5>>,>>> )fter the sales increase6 'a( HO3 < =1B+,>>> = B+,>>> 'b( HO3 < =00>,>>> =*0>,>>> 'c( HO3 < =0.+,>>> =*.+,>>> 'd( HO3 < =++>,>>> =5+>,>>> < @.>> < 0.>> < 1.>> < 5.+>

< 0.+1 < 1.*0 < 5.+0 < 5.5>

15,<

A##en(i. 15,

Jote how as sales, hence BIT, rises, HO3 declines. SO:UTION PRO,:E; 15,1> HO3 < contribution BIT -rior to the sales increase6 'a( HO3 < =*+>,>>> = 1>,>>> 'b( HO3 < =*B>,>>> = 9>,>>> 'c( HO3 < =5*>,>>> = .>,>>> 'd( HO3 < =50>,>>> =*5>,>>> )fter the sales increase6 'a( HO3 < =*B@,+>> = 9@,+>> 'b( HO3 < =55+,>>> =*>+,>>> 'c( HO3 < =595,+>> =*05,+>> 'd( HO3 < =1>>,>>> =*B>,>>> < 5.@B < 5.*0 < *.B0 < *.9@ < +.>> < 1.>> < 5.11 < 5.>>

Jote how as sales, hence BIT, rises, HO3 declines. SO:UTION PRO,:E; 15,11 #onstruct the bottom lines of the company's income statement6 BIT Interest BT Taxes )T A $hares 'a( =+>>,>>> > +>>,>>> *@+,>>> 15+,>>> 5>,>>> 'b( =+>>,>>> *>>,>>> 0>>,>>> *0>,>>> 59>,>>> 5>,>>> 'c( =+>>,>>> 5>>,>>> 1>>,>>> *>+,>>> *.+,>>> 5>,>>> 'd( =+>>,>>> 1>>,>>> 5>>,>>> @>,>>> *1>,>>> 5>,>>>

;easurin the 'e ree ") :evera e

-$ = *9.5+ = *1.>> = ..@+ = 9.+>

15,=

SO:UTION PRO,:E; 15,1& #onstruct the bottom lines of the company's income statement6 BIT Interest BT Taxes )T A $hares -$ 'a( =5,+>>,>>> > 5,+>>,>>> B@+,>>> *,95+,>>> *+>,>>> = *>.B1 'b( =5,+>>,>>> +>>,>>> 5,>>>,>>> @>>,>>> *,1>>,>>> *+>,>>> = B.9@ 'c( =5,+>>,>>> *,>>>,>>> *,+>>,>>> +5+,>>> .@+,>>> *+>,>>> = 9.+> 'd( =5,+>>,>>> *,+>>,>>> *,>>>,>>> 1+>,>>> 9+>,>>> *+>,>>> = 0.11

SO:UTION PRO,:E; 15,1* 8edo the income statements of problem *+B** with BIT of =++>,>>>6 BIT Interest BT Taxes )T A $hares -$ 'a( =++>,>>> > ++>,>>> *.5,+>> 1+@,+>> 5>,>>> = *@.BB 'b( =++>,>>> *>>,>>> 0+>,>>> *+@,+>> 5.5,+>> 5>,>>> = *0.91 'c( =++>,>>> 5>>,>>> 1+>,>>> *55,+>> 55@,+>> 5>,>>> = **.1B 'd( =++>,>>> 1>>,>>> 5+>,>>> B@,+>> *95,+>> 5>,>>> = B.*1

15,1>

A##en(i. 15,

-$ was #hange to -$

=*9.5+ = *.91

=*1.>> = *.91

= ..@+ = *.91

= 9.+> = *.91

%easured in absolute dollars, -$ increases by =*.91 in all four cases. -ercentage change to 'a( =*.91L=*9.5+ 'b( =*.91L=*1.>> 'c( =*.91L= ..@+ 'd( =*.91L= 9.+> -$ < *>.>1, < *5.+0, < *9.@5, < 5+.>B, '*>, without roundoff error( Jote6 greater percentage '*5.+>, without roundoff error( change with higher '*9.9@, without roundoff error( fixed costs 'interest(. '5+.>>, without roundoff error(

SO:UTION PRO,:E; 15,1+ 8edo the income statements of problem *+B*5 with BIT of =1,>>>,>>>6 BIT Interest BT Taxes )T A $hares -$ -$ was 'a( =1,>>>,>>> > 1,>>>,>>> *,>+>,>>> *,.+>,>>> *+>,>>> = *1.>> = *>.B1 'b( =1,>>>,>>> +>>,>>> 5,+>>,>>> B@+,>>> *,95+,>>> *+>,>>> = *>.B1 = B.9@ 'c( =1,>>>,>>> *,>>>,>>> 5,>>>,>>> @>>,>>> *,1>>,>>> *+>,>>> = B.9@ = 9.+> 'd( =1,>>>,>>> *,+>>,>>> *,+>>,>>> +5+,>>> .@+,>>> *+>,>>> = 9.+> = 0.11

#hange to -$ = 5.*@ = 5.*@ = 5.*@ = 5.*@ %easured in absolute dollars, -$ increases by =5.*@ in all four cases. -ercentage change to 'a( =5.*@L=*>.B1 'b( =5.*@L= B.9@ 'c( =5.*@L= 9.+> 'd( =5.*@L= 0.11 -$ < 5>.>0, < 5+.>1, < 11.1B, < +>.*5, '5>, without roundoff error( Jote6 greater percentage '5+, without roundoff error( change with higher '11.11, without roundoff error( fixed costs 'interest(. '+>, without roundoff error(

SO:UTION PRO,:E; 15,15 '*( #onstruct income statements for each BIT level6 'a( 'b( 'c( 'd(

;easurin the 'e ree ") :evera e

BIT Interest BT Taxes )T A $hares -$ =0>>,>>> 5>>,>>> 5>>,>>> @>,>>> *1>,>>> 1+,>>> = 1.@* =9>>,>>> 5>>,>>> 0>>,>>> *0>,>>> 59>,>>> 1+,>>> = @.01 =B>>,>>> 5>>,>>> 9>>,>>> 5*>,>>> 1.>,>>> 1+,>>> = **.*0 =*,>>>,>>> 5>>,>>> B>>,>>> 5B>,>>> +5>,>>> 1+,>>> = *0.B9

15,11

'5( Increase each BIT number by *>, and construct new income statements6 BIT Interest BT Taxes )T A $hares -$ '1( #ompare -$ levels6 'a( #hange < =0.09 =1.@* < =>.@+ -ercentage change < =>.@+ < 5>.55, =1.@* 'b( #hange < =B.+0 =@.01 < -ercentage change < =*.** =@.01 'c( #hange < =*5.91 =**.*0 -ercentage change < =*.0. =**.*0 =*.** < *0..0, < =*.0. < *1.1B, 'a( =00>,>>> 5>>,>>> 50>,>>> B0,>>> *+9,>>> 1+,>>> = 0.09 'b( =99>,>>> 5>>,>>> 09>,>>> *9*,>>> 5..,>>> 1+,>>> = B.+0 'c( =BB>,>>> 5>>,>>> 9B>,>>> 51B,>>> 005,>>> 1+,>>> = *5.91 'd( =*,*>>,>>> 5>>,>>> .>>,>>> 1*+,>>> +B+,>>> 1+,>>> = *9.@*

'd( #hange < =*9.@* =*0.B9 < =*.B+ -ercentage change < =*.B+ < *5.0+, =*0.B9 4hile the absolute change increases as BIT goes up, the percentage change decreases as the firm's BT rises. SO:UTION PRO,:E; 15,11 '*( #onstruct income statements for each BIT level6

15,1&

A##en(i. 15,

BIT Interest BT Taxes )T A $hares -$

'a( =5+>,>>> B>,>>> *@>,>>> +.,+>> **>,+>> *5,>>> = ..5*

'b( =1>>,>>> B>,>>> 55>,>>> @@,>>> *01,>>> *5,>>> = **..5

'c( =1+>,>>> B>,>>> 5@>,>>> .0,+>> *@+,+>> *5,>>> = *0.91

'd( =0>>,>>> B>,>>> 15>,>>> **5,>>> 5>B,>>> *5,>>> = *@.11

'5( Increase each BIT number by 5+, and construct new income statements6 BIT Interest BT Taxes )T A $hares -$ '1( #ompare -$ levels6 'a( #hange < =*5.+. =..5* < =1.1B -ercentage change < =1.1B < 19.@>, =..5* 'b( #hange < =*+..B =**..5 < =0.>9 -ercentage change < =0.>9 < 10.>+, =**..5 'c( #hange < =*..19 =*0.91 < =0.@1 -ercentage change < =0.@1 < 15.11, =*0.91 'd( #hange < =55.@+ =*@.11 < =+.05 -ercentage change < =+.05 < 1*.5B, =*@.11 4hile the absolute change increases as BIT goes up, the percentage change decreases as the firm's BT rises. 'a( =1*5,+>> B>,>>> 515,+>> B*,1@+ *+*,*5+ *5,>>> = *5.+. 'b( =1@+,>>> B>,>>> 5.+,>>> *>1,5+> *.*,@+> *5,>>> = *+..B 'c( =01@,+>> B>,>>> 1+@,+>> *5+,*5+ 515,1@+ *5,>>> = *..19 'd( =+>>,>>> B>,>>> 05>,>>> *0@,>>> 5@1,>>> *5,>>> = 55.@+

;easurin the 'e ree ") :evera e

SO:UTION PRO,:E; 15,15 H"3 < BIT earnings before taxes

15,1*

"rom problem *+B**6 'a( H"3 < =+>>,>>> =+>>,>>> < =+>>,>>> =0>>,>>> < =+>>,>>> =1>>,>>> < =+>>,>>> =5>>,>>> < * 4ith no fixed financing costs 'interest(, H"3 always < *

'b( H"3 'c( H"3 'd( H"3

< *.5+ )s fixed financing costs 'interest( rise, BT < *.9@ declines relative to BIT, and H"3 rises. < 5.+>

In problem *+B*1, BIT increased to =++>,>>> 'from =+>>,>>> in problem *+B **(, a *>, increase. )pplying the H"3 numbers from above to the *>, change in BIT gives the percentage change to -$ in problem *+B*16 'a( *>,'*( < *>.>>, 'b( *>,'*.5+( < *5.+>, 'c( *>,'*.9@( < *9.9@, 'd( *>,'5.+>( < 5+.>>, SO:UTION PRO,:E; 15,1< H"3 < BIT earnings before taxes

"rom problem *+B*56 'a( H"3 < =5,+>>,>>> < * =5,+>>,>>> 4ith no fixed financing costs 'interest(, H"3 always < *

'b( H"3 'c( H"3 'd( H"3

< =5,+>>,>>> < *.5+ =5,>>>,>>> )s fixed financing costs 'interest( rise, BT < =5,+>>,>>> < *.9@ declines relative to BIT, and H"3 rises. =*,+>>,>>> < =5,+>>,>>> < 5.+> =*,>>>,>>>

15,1+

A##en(i. 15,

In problem *+B*0, BIT increased to =1,>>>,>>> 'from =5,+>>,>>> in problem *+B*5(, a 5>, increase. )pplying the H"3 numbers from above to the 5>, change in BIT gives the percentage change to -$ in problem *+B*06 'a( 5>,'*( < 5>.>>, 'b( 5>,'*.5+( < 5+.>>, 'c( 5>,'*.9@( < 11.11, 'd( 5>,'5.+>( < +>.>>, SO:UTION PRO,:E; 15,1= H"3 < BITMM earnings before taxes

-rior to the BIT increase6 'a( H"3 'b( H"3 'c( H"3 'd( H"3 < < < < =0>>,>>> =5>>,>>> =9>>,>>> =0>>,>>> =B>>,>>> =9>>,>>> =*,>>>,>>> =B>>,>>> < < < < 5.>> *.+> *.11 *.5+

)fter the BIT increase6 'a( H"3 < =00>,>>> =50>,>>> 'b( H"3 < =99>,>>> =09>,>>> 'c( H"3 < =BB>,>>> =9B>,>>> 'd( H"3 < =*,*>>,>>> =.>>,>>> Jote how as BIT, hence < *.B1 < *.01 < *.5. < *.55 BT rises, H"3 declines.

SO:UTION PRO,:E; 15,&> H"3 < BIT earnings before taxes

;easurin the 'e ree ") :evera e

-rior to the BIT increase6 'a( H"3 'b( H"3 'c( H"3 'd( H"3 < =5+>,>>> =*@>,>>> < =1>>,>>> =55>,>>> < =1+>,>>> =5@>,>>> < =0>>,>>> =15>,>>> < *.0@ < *.19 < *.1> < *.5+

15,15

)fter the BIT increase6 'a( H"3 'b( H"3 'c( H"3 'd( H"3 < =1*5,+>> =515,+>> < =1@+,>>> =5.+,>>> < =01@,+>> =1+@,+>> < =+>>,>>> =05>,>>> < *.10 < *.5@ < *.55 < *.*.

Jote how as BIT, hence BT rises, H"3 declines. SO:UTION PRO,:E; 15,&1 'a( $ales =5,>>>,>>> ?ariable cost *,*>>,>>> #ontribution .>>,>>> "ixed cost 9>>,>>> BIT 1>>,>>> Interest *>>,>>> BT 5>>,>>> Taxes @>,>>> )T *1>,>>> Ashares *+>,>>> -$ =>.B@ 'b( HO3 < contribution < =.>>,>>> < 1.>> BIT =1>>,>>> ++, of sales

15,11
H"3 HT3 'c( 'd( $ales =5,1>>,>>> ?ariable cost *,59+,>>> #ontribution *,>1+,>>> "ixed cost 9>>,>>> BIT 01+,>>> Interest *>>,>>> BT 11+,>>> Taxes **@,5+> )T 5*@,@+> Ashares *+>,>>> -$ =*.0+ up *+, '++, of sales( < BIT < =1>>,>>> BT =5>>,>>> < *.+>

A##en(i. 15,

< contribution < =.>>,>>> < 0.+> BT =5>>,>>> < 1.>> *.+> < 0.+>

HO3 H"3

up 0+,

up 9@,

"rom HO3, BIT should increase by *+,'1.>>( < 0+, "rom H"3, -$ should increase by 0+,'*.+>( < 9@.+, 'roundoff error( "rom HT3, -$ should increase by *+,'0.+>( < 9@.+, SO:UTION PRO,:E; 15,&& 'a( $ales =+>>,>>> ?ariable cost *@+,>>> #ontribution 15+,>>> "ixed cost *5+,>>> BIT 5>>,>>> Interest +>,>>> BT *+>,>>> Taxes +5,+>> )T .@,+>> Ashares @+,>>> -$ =*.1> 1+, of sales

;easurin the 'e ree ") :evera e

'b( HO3 < contribution < =15+,>>> < *.91 BIT =5>>,>>> H"3 HT3 'c( < BIT < =5>>,>>> BT =*+>,>>> < *.11

15,15

< contribution < =15+,>>> < 5.*@ BT =*+>,>>> < *.91 *.11 < 5.*@

HO3 H"3

'd( $ales =95+,>>> ?ariable cost 5*B,@+> #ontribution 0>9,5+> "ixed cost *5+,>>> BIT 5B*,5+> Interest +>,>>> BT 51*,5+> Taxes B>,.1B )T *+>,1*5 Ashares @+,>>> -$ =5.>> up 5+, '1+, of sales(

up 0>.9,

up +1..,

"rom HO3, BIT should increase by 5+,'*.91( < 0>.B, 'roundoff error( "rom H"3, -$ should increase by 0>.9,'*.11( < +0.>, 'roundoff error( "rom HT3, -$ should increase by 5+,'5.*@( < +0.1, 'roundoff error(*@