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University of Southern Philippines Foundation

College of Accountancy
Salinas Drive, Lahug, Cebu City

Integrated Case Study on


Campus Deli
And
Ski Equipment Inc.

Submitted by:
Finance 3 Class

Submitted to:
Mr. Michael Angelo Abarcar

Chapter 15 Capital Structure and Leverage


15-15

OPTIMAL CAPITAL STRUCTURE

Assume you have just been hired as business manager

of Campus Deli (CD), which is located adjacent to the campus. Sales were $1,100,000 last year, variable
costs were 60% of sales, and fixed cost were $40,000. Therefore, EBIT totalled $400,000. Because the
universitys enrolment is capped, EBIT, is expected to be constant overtime. Because no expansion
capital is required, CD pays out all earnings as dividends. Assets are $2 million, and 80,000 shares are
outstanding. The management group owns about 50% of the stock, which is traded in the over-thecounter market.
CD currently has no debt it is an all-equity firm and its 80,000 shares outstanding sell at a
price of $25 per share, which is also the book value. The firms federal-plus-tax rate is 40%. On the basis
of statements made in your finance text, you believe that CDs shareholders would be better off if some
debt financing was used. When you suggested this to your new boss, she encouraged you to pursue the
idea but to provide support for the suggestion.
In todays market, the risk-free rate, r RF, is 6% and the market risk premium, RP M, is 6%. CDs
unlevered beta, bU, is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 12%.
If the firm was recapitalized, debt would be issued and the borrowed funds would be used to
repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in
other fast-food companies similar to CD. You plan to complete your report by asking and then answering
the following questions.

a.

(1.)

What is business risk? What factors influence a firms business risk?


Business risk is the single most important determinant of capital structure, and it

represents the amount of risk that is inherent in the firms operations even if it uses no debt financing.
Business risk depends on a number of factors, the more important of which are:

1. Demand Variability. The more stable the demand for a firms products, other things held
constant, the lower its business risk.
2. Sales price variability. Firms whose products are sold in highly volatile markets are exposed
to more business risk than similar firms whose output prices are more stable.
3. Input cost variability. Firms whose input costs are highly uncertain are exposed to a high
degree of business risk.
4. Ability to adjust output prices for changes in input costs. Some firms are better able than
others to raise their own output prices when input costs rise. The greater the ability to adjust
output prices to reflect cost conditions, the lower the degree of business risk.
5. Ability to develop new products in a timely, cost-effective manner. Firms in high-tech
industries such as drugs and computers depend on a constant stream of new products. The
faster a firms products become obsolete, the greater the firms business risk.
6. Foreign risk exposure. Firms that generate a high percentage of their earnings overseas are
subject to earnings declines due to exchange rate fluctuations. Also, if a firm operates in a
politically unstable area, it may be subject to political risk.
7. The extent to which costs are fixed: operating leverage. If a high percentage of its costs are
fixed, the firm will be exposed to a relatively high degree of business risk. This factor is called
operating leverage, and it is discussed at length in the next section.

(2.)

What is operating leverage, and how does it affect a firms business risk?
Operating leverage is the extent to which fixed costs are used in a firms operations. In general,

holding other factors constant, the higher the degree of operating leverage, the greater the firms business
risk.

b.

(1.)

What do the terms financial leverage and financial risk mean?

Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are
used in a firms capital structure.
Financial risk is an increase in stockholders risk, over and above the firms basic business risk,
resulting from the usage of financial leverage.
(2.)

c.

How does financial risk differ from business risk?

To develop an example that can be presented to CDs management as an illustration, consider

two hypothetical firms: Firms U with zero debt financing and Firm L with $10, 000 of 12% debt. Both firms
have $ 20, 000 in total assets and a 40% federal-plus-state tax rate, and they have the following EBIT
probability distribution for the next year:
Probability

EBIT

0.25

$ 2,000

0.50

3,000

0.25

4,000

(1) Complete the partial income statements and the firms ratios in Table IC 15-1.
(2) Be prepared to discuss each entry in the table and to explain how this example illustrates the
effect of financial leverage on expected rate of return and risk.
d. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at
different levels (in thousands of dollars):
Now consider the optimal capital structure for CD.
(1) To begin, define the terms optimal structure and target capital structure.

Optimal Capital Structure is the best debt-to-equity ratio for a firm that maximizes its
value. The optimal capital structure for a company is one which offers a balance between the
ideal debt-to-equity range and minimizes the firms cost of capital. In theory, debt financing
generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the
optimal structure since a companys risk generally increases as debt increases.
Target capital structure is defined as the mix of debt, preferred stock and common equity
that will optimize the companys stock price. As a company raises new capital it will focus on
maintaining this target capital structure.

(2) Why does CDs bond rating and cost of debt depend on the amount of money borrowed?

Income statements and ratios


Firm U
Assets
Equity
Probability
Sales
Operating costs
Earnings before
interest and taxes
Interest (12%)
Earnings before
taxes
Taxes (40%)
Net income
Basic Earning power
(BEP= EBIT/Assets)
ROE
TIE
Expected basic
earning power
Expected ROE

Firm L

$ 20,000
$ 20,000
0.25
$ 6,000
4,000

$ 20,000
$ 20,000
0.50
$ 9,000
6,000

$ 20,000
$ 20,000
0.25
$12,000
8,000

$ 20,000
$ 10,000
0.25
$ 6,000
4,000

$ 20,000
$ 10,000
0.50
$ 9,000
6,000

$ 20,000
$ 10,000
0.25
$ 12,000
8,000

$ 2,000
0
$ 2,000

$ 3,000
0
$ 3,000

$ 4,000
0
$ 4,000

$ 2,000
1,200
$ 800

$ 3,000
1,200
$1,800

$ 4,000
1,200
$ 2,800

800
$ 1,200

1,200
$ 1,800

1,600
$ 2,400

320
$ 480

720
$1080

1, 120
$ 1,680

10.0 %
6.0 %

15.0 %
9.0 %

20.0 %
12.0 %

10.0 %
4.8 %
1.7 x

15%
10.8%
2.5x

20.0 %
16.8 %
3.3x

15.0 %
9.0 %

15%
10.8%

Expected TIE
BEP
ROE
TIE

3.5 %
2.1 %
0

2.5x
%
4.2%
0.6x

(3) Assume that shares could be repurchased at the current market price of $25 per share. Calculate
CDs expected EPS and TIE at debt levels of $0, $250,000, $ 500,000, $ 750,000, and $
1,000,000. How many shares would remain after recapitalization under each scenario?

a. zero debt
EPS

= Net Income/No. of shares


= 240,000/80,000
= 3.00

TIE

Remaining shares: 80,000


b. 250,000 debt; 8%
EPS

= 240,000/70,000
= 3.43

TIE

= 400,000/20,000
= 20x

Remaining shares 70,000


c. 500,000 debt; 9%
EPS

= 240,000/60,000

= 4.00
TIE

= 400,000/45,000
= 8.89x

d. 750,000 debt; 11.5%


EPS

= 240,000/50,000
= 4.8

TIE

= 400,000/86250
= 4.64x
e. 1,000,000 debt; 14%

EPS

= 240,000/40,000
=6

TIE

= 400,000/140,000
= 2.86x

(4) Using the Hamada equation, what is the cost of equity if CD recapitalizes with $ 250,000 of debt?
$ 500,000? $ 750,000? $ 1,000,000?

BL

bu[1+(1-T)(D/E)]

a. 250,000
= 1 [1+(1-0.40)(0.1429)]
= 1.09

b. 500,000
= 1 [1+(1-0.40)(0.3333)]
= 1.20

c. 750,000

= 1 [1+(1-0.40)(0.6000)]
= 1.36

d. 1,000,000
= 1 [1+(1-0.40)(1.0000)]
= 1.6
(5) Considering only the levels of debt discussed, what is the capital structure that minimizes CDs
WACC?

The capital structure with 25% debt would minimize the WACC
(6) What would be the new stock price if CD recapitalizes with $250,000 of debt? $ 500,000?
$750,000? $1,000,000? Recall the payout ratio is 100 %, so g=0.

b. 250,000 debt; 8%
EPS

= 240,000/70,000
= 3.43

c. 500,000 debt; 9%

EPS

= 240,000/60,000
= 4.00

d. 750,000 debt; 11.5%


EPS

= 240,000/50,000
= 4.8

e. 1,000,000 debt; 14%


EPS

= 240,000/40,000
=6

(7) Is EPS maximized at the debt level that maximizes share price? Why or why not?
(8) Considering only the levels of debt discussed, what is CDs optimal capital structure?

The optimal capital structure is the one that has 75% equity and 25% debt
(9) What is the WACC at the optimal capital structure?

11.25%
e. Suppose you discovered that CD had more business risk than you originally estimated. Describe how
this would affect the analysis. How would the analysis be affected if the firm had less business risk than
originally estimated?
If the company would go into bankruptcy, the company will assume all the loses and necessary payments
that the company would incur. If the business has less business risk than what they have estimated, the
companys debt ratio will be zero.
f. What are some factors a manager should consider when establishing his or her firms target capital
structure?
Debt ratios of other firms in the industry
Pro forma coverage ratios at different capital structures under different economic scenarios.

Lender and rating agency attitudes (impact on bond ratings).


Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible, and hence suitable as collateral?
Tax rates.

g. Put labels on Figure IC 15-1 and then discuss the graph as you might use it to explain to your boss why
CD might want to use some debt.
CD should some debt in order to finance some of their assets and it is costly if theyre going to finance it
using equity financing. Thus, debt financing is less costly than equity financing.
h. How does the existence of asymmetric information and signalling affect capital structure?
Through providing prospects to the investors about the firm, asymmetric information and signalling
increases the firms capital structure by selling stocks, raising investments and reducing additional losses.
A firm with very favourable prospects avoid selling stock and instead raise any required new capital by
using new debt even if this moved its debt ratio beyond the target level. And a firm with unfavourable
prospects would want to finance with stock, which would mean bringing in new investors to share the
losses.

Chapter 17 Working Capital Management

Ski Equipment Inc.


17-12 MANAGING CURRENT ASSETS Dan Barnes, Financial manager of Ski Equipment Inc. (SKI) is
excited, but apprehensive. The companys founder recently sold his 51 % controlling block of stock to
Kent Koren, who is a big fan of EVA (Economic Value Added). EVA is found by taking the after-tax
operating profit and subtracting the dollar cost of all the capital the firm uses.
EVA = EBIT (1-T) Capital costs
= EBIT (1-T) WACC (Capital employed)

If EVA is positive, the firm is creating value. On the other hand, if EVA is negative, the firm is not
covering its cost of capital and stockholders value is being eroded. Koren rewards managers handsomely
if they create value, but those whose operations produce negative EVAs are soon looking for work. Koren
frequently points out that if a company can generate its current level of sales with fewer assets, it will
need less capital. That would, other things held constant, lower capital costs and increase EVA.
Shortly after he took control of SKI, Koren met with SKIs senior executives to tell them of his
plans for the company. First, he presented some EVA data that convinced everyone that SKI had not been
creating value in recent years. He then stated, in no uncertain terms, that this situation must change. He
noted that SKIs designs of skis, boots, and clothing are acclaimed throughout the industry but that
something is seriously amiss elsewhere in the company. Costs are too high, prices are too low, orthe
company employs too much capital; and he expects SKIs managers to correct the problem.
Barnes has long believed that SKIs working capital situation should be studied- the company
may have the optimal amounts of cash, securities, receivables, and inventories; but it may also have too
much or too little of these items. In the past, the production manager resisted Barnes efforts to question
his holdings of raw materials inventories, the marketing manager resisted questions about finished goods,

the sales staff resisted questions about credit policy, and the treasurer did not want to talk about her cash
and securities balances. Korens speech made it clear that such resistance would no longer be tolerated.
Barnes also knows that decisions about working capital cannot be made in a vacuum. For
example, if inventories could be lowered without adversely affecting operations, less capita would be
required, the dollar cost of capital would decline, and EVA would increase. However, lower raw materials
inventories might lead to production slowdowns and higher costs, while lower finished goods inventories
might lead to the loss of profitable sales. So, before inventories are changed, it will be necessary to study
operating as well as financial effects. The situation is the same with regard to cash and receivables.
a. Barnes plans to use the ratios in Table IC 17-1 as the starting point for discussions with SKIs
operating executives. He wants everyone to think about the pros and cons of changing each type
of current asset and the way changes would interact to affect profits and EVA. Based on the data
in Table IC 17-1, does SKI seem to be following a relaxed, moderate, or restricted working capital
policy?
Ski Equipment Inc. (SKI) is following a relaxed working capital policy because its ratios
are relatively lower than that of the industry's ratios. These ratios indicate SKI has large amounts
of working capital relative to its level of sales.

Table IC 17-1

Selected ratios: SKI and industry average


SKI

Industry

1.75

2.25

58.76 %

50.00 %

Turnover of cash and securities

16.67

22.22

Days sales outstanding (365-day basis)

45.63

32.00

Inventory turnover

4.82

7.00

Fixed assets turnover

11.35

12.00

Total Assets Turnover

2.08

3.00

2.07%

3.50 %

10.45 %

21.00 %

Current
Debt/Assets

Profit margin
Return on equity (ROE)

b. How can we distinguish between a relaxed but rational working capital policy and a situation
where a firm has a large amount of current assets simply because it is inefficient? Does SKIs
working capital policy seem appropriate? Explain.
A relaxed policy may be appropriate if it reduces risk more than profitability. However,
SKI is much less profitable than the average firm in the industry. This suggests that the company
probably has excessive working capital

c.

SKI tries to match the maturity of its assets and liabilities. Describe hoe SKI could adopt a more
aggressive or a more conservative financing policy.

SKI could adopt an aggressive approach by financing some of its permanent assets with shortterm debt. This policy would be a highly aggressive, extremely non-conservative position; and SKI
would be subject to dangers from loan renewal as well as problems with rising interest rates.
However, short-term interest rates are generally lower than long-term rates, and some firms are

willing to sacrifice some safety for the chance of higher profits. On the other hand, SKI could also
adopt a conservative approach by financing all of its permanent assets with long-term debts. In this
situation, SKI uses a small amount of short-term credit to meet its peak requirements, but it also
meets part of its seasonal needs by storing liquidity in the form of marketable securities. This is a
very safe conservative financial policy.
d.

Assume that SKIs payables deferral period is 30 days. Now, calculate the firms cash conversion
cycle.

Inventory Conversion + Inventory Collection - Payables Deferral = Cash Conversion


Period
Period
Period
Cycle
4.82
+
45.63
30
=
20.45

e. What should SKI do to reduce its cash and securities without harming operations?

Hold marketable securities instead of a cash storing liquidity.


In an attempt to better understand SKIs cash position, Barnes developed a cash budget. Data for the first
2 months of the year are shown in Table IC 17-2. (Note that Barness preliminary cash budget does not
account for interest income or interest expense.) He has the figures for the other months, but they are not
shown in Table IC 17-2.

f.

In his preliminary cash budget, Barnes has assumed that all sales are collected and thus, that
SKI has no bad debts. Is this realistic? If not, how would bad debts be dealt with in a cash
budgeting sense? (Hint: Bad debts affect collections but not purchases.)
No, this is not realistic. SKI cannot be so certain that all sales would be collected because there

is what we call as credit risk. Bad debts would arise when some of the receivables would be deemed
uncollectible. So, it would reduce the cash inflows and would result to lower cash budget.

g. Barness cash budget for the entire year, although not given here, is based heavily on his forecast
for monthly sales. Sales are expected to be extremely low between May and September but then
increase dramatically in the fall and winter. November is typically the firms best month, when SKI
ships equipment to retailers for the holiday season. Interestingly, Barness forecasted cash
budget indicates that the companys cash holdings will exceed the targeted cash balance every
month except October and November, when shipments will be high but collections will not be
coming in until later. Based on the ratios in Table IC 17-1, does it appear that SKIs target cash
balance is appropriate? In addition to possibly lowering the target cash balance, what actions
might SKI take to better improve its cash management policies and how might that affect its EVA?

Cash budget indicates the company probably is holding too much cash.

h. Is there any reason to think that SKI may be holding too much inventory? If so, how much would
that affect EVA and ROE?

SKIs inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is
carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its
operating costs which reduce its EBIT. Moreover, the excess inventory must be financed, so EVA is
further lowered.

i.

If the company reduces its inventory without adversely affecting sales, what effect should this
have on the companys cash position (1) in the short run and (2) in the long run? Explain in terms
of the cash budget and the balance sheet.
Short run: Cash will increase as inventory purchases decline.
Long run: Company is likely to then take steps to reduce its cash holdings.

j.

Barnes knows that SKI sells on the same credit terms as other firms in the industry. Use the ratios
presented in Table IC 17-1 to explain whether SKIs customers pay more or less promptly than
those of its competitors. If there are differences, does that suggest that SKI should tighten or
loosen its credit policy? What four variables make up a firms credit policy, and in what direction
should each be changed by SKI?

SKIs days sales outstanding (DSO) of 45.63 days is well above the industry average (32
days). SKIs customers are paying less promptly. So, SKI should consider tightening its credit
policy to reduce its DSO.
Cash Discounts: Lowers price. Attracts new customers and reduces DSO.

Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may
discourage sales. Credit Standards: Tighter standards reduce bad debt losses, but may reduce
sales. Fewer bad debts reduces DSO.
Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.

k.

Does SKI face any risks if it tightens its credit policy? Explain.

YES!

A tighter credit policy may discourage sales.

Some customers may

choose to go elsewhere if they are pressured to pay their bills sooner


l.

If the company reduces its DSO without seriously accepting sales, what effect will this have on its
cash position (1) in the short run and (2) in the long run? Answer in terms of the cash budget and
the balance sheet. What effect should this have on EVA in the long run?

Short run: If customers pay sooner, this increases cash holdings.


Long run: Over time, the company would hopefully invest the cash in more
productive assets, or pay it out to shareholders. Both of these actions would
increase EVA

m. Assume that SKI buys on terms of 1/10, net 30, but that it can get away with paying on the 40 th
day if it chooses not to take discounts. Also, assume that it purchases $ 3 million of components
per year, net of discounts. How much free trade credit can the company get, how much costly
trade credit can it get, and what is the percentage cost of the costly credit? Should SKI take
discounts? Why or why not?

Company buys goods worth $3million. Thats the cash price. They must pay
$30,000 more over the year if they forego the discount. SKI should take
discounts because it would be good for the cash budget

n. Suppose SKI decided to raise an additional $1,000,000 as a 1-year loan from its bank, for which it
was quoted a rate of 8%. What is the effective annual cost rate assuming simple interest and
add-on interest on a 12 month instalment loan?
E= (1+J/m)m -1
= (1+0.08/12)12 -1
= 8.30%