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MB 102 Tutorial 11 Capital Structure and Leverage Group 10 Chua Liping Ang Wei Ping Chong Pick Yee Ahmad Zaki Bin Salleh Shawn Tien Wei Chong 29 November 2010, 4.30pm P15-5 FINANCIAL LEVERAGE EFFECT The firms HL and LL are identical except for their leverage ratios and interest rates they pay on debt. Each has $20 million in assets, earned $4 million of EBIT, and is in the 40 percent federal-plus-state tax bracket. Firm HL, however, has a debt ratio (D/A) of 50 percent and pays 12 percent interest on its debt, whereas LL has 30 percent debt ratio and pays only 10 percent interest on its debt. Calculate the rate of return on equity (ROE) for each firm. b. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt ratio from 30 to 60 percent, even though that would increase LL’s interest rate on all debt to 15 percent. Calculate the new ROE for LL. HL LL Assets 20m 20m EBIT 4m 4m Tax 40% 40% Leverage ratio 50:50 30:70 10m:10m 6m:14m Interest 12% 10% 1.2m 0.6m P15-5a.Calculate the ROE for each firm. P15-5a.Calculate the ROE for each firm. HL ($ in million) LL ($ in million) EBIT 4 4 Interest 1.2 0.6 EBT (EBIT – Interest) 2.8 3.4 Tax (EBT x 40%) 1.12 1.36 NI (EBT – Tax) 1.68 2.04 P15-5a.Calculate the ROE for each firm. P15-5b. Calculate new ROE for LL. LL Leverage ratio 60:40 12m:8m Interest 15% 1.8m $ in million EBIT 4 Interest 1.8 EBT 2.2 Tax (40%) 0.88 NI 1.32 P15-6 BREAKEVEN ANALYSIS The Weaver Watch Company sells watches for $25; the fixed costs are $140,000 and the variable costs are $15 per watch. What is the firm’s gain or loss at sales of 8,000 watches? At 18,000 watches? What is the breakeven point? Illustrate by means of a chart. What would happen to the breakeven point if the selling price were raised to $31 but variable costs rose to $23 a unit? P15-6a. What is the firm’s gain or loss at sales of 8,000 watches? At 18,000 watches? At sales of 8,000 watches, Total Revenue = $25 x 8,000 =