Leverage, Capital Structure, and Dividend Policy

/in /by

Module 4 – Case

Leverage, Capital Structure, and Dividend Policy

Before starting on this assignment, make sure to carefully review the
background readings. Part A requires you to make some computations, and
Part B requires you to analyze some scenarios using your knowledge of
the concepts. So make sure to go through the computational examples in
the required readings and also thoroughly review the key concepts before
starting on this assignment.

Case Assignment

Part A: Quantitative Problems

  1. Suppose QuickCharge Corporation manufactures phone chargers. They
    sell their chargers for $20. Their fixed operating costs are $100,000
    and their variable operating costs are $10 per charger. Currently they
    are selling 30,000 chargers per year.

    1. What is QuickCharge’s EBIT (earnings before interest and taxes) at current sales of 30,000?
    2. What is QuickCharge’s breakeven point?
    3. Calculate the EBIT if QuickCharge’s sales increase 50% to 45,000
      chargers. What is the percent of change in EBIT under this increase in
      sales? Also, calculate the EBIT if the company’s sales decrease 50% to
      15,000 chargers. What is the percent of change in EBIT under this
      decrease in sales?
    4. What is QuickCharge’s degree of operating leverage? Based on your
      computation, what does its operating leverage say about QuickCharge’s
      business risk?
  2. The StayDry Umbrella Corporation will have an EBIT of $100,000 if
    there is a normal amount of rain this year. But if there is a drought,
    they will have an EBIT of only $50,000. The interest rate on debt is
    10%, and the tax rate is 35%. The company does not pay any preferred
    dividends.

    1. If StayDry has zero debt and 50,000 outstanding shares, what will
      its EPS (earnings per share) be if there is normal rain? What will its
      EPS be if there is a drought? What is its DFL (degree of financial
      leverage)?
    2. Now suppose StayDry has decided to take on $300,000 in debt and has
      used these funds to buy back half of the outstanding shares so now there
      are only 25,000 outstanding shares. What is the new EPS and DFL for
      both normal rain and drought?
    3. Based on your answers to a) and b) above, what are the trade-offs
      management has to make between zero debt or $300,000 in debt? What are
      the benefits and disadvantages of taking on this debt?

Part B: Conceptual Questions

  1. For each of the following scenarios, explain whether the situation describes financial risk or business risk. Explain your answers to each scenario using at least one of the references from the background readings:
    1. A pharmaceutical company has developed a new cancer treatment drug
      that has a much higher success rate than other drugs currently in the
      market. It has the potential to triple the company’s profits. However,
      the FDA has expressed concern about some side effects, and it is not
      clear if the FDA will approve the drug.
    2. An airline has an EBIT of $100 million per year. However, it also
      has a huge amount of debt and pays $97 million per year in interest. Its
      EBIT is relatively stable but tends to go up or down by $5 million or
      so each year depending on the economy.
    3. A basketball franchise earns an EBIT of $50 million a year when its
      team has a winning year. However, it earns only $10 million when its
      team has a losing year.
  2. Explain what capital structure theory (or theories) best describes
    the following situations. Make sure to cite at least one of the required
    textbook chapters for each answer, and to cite at least two references
    for this section:

    1. A CEO decides to borrow $50,000 in new debt, and the share prices
      rise dramatically. He then decides to sell half of his own personal
      shares, and when this is reported in the Wall Street Journal, the share
      prices drop dramatically in value.
    2. The corporate tax rate rises from 35% to 45%, and the XYZ
      Corporation decides to issue more debt. A year later, bankruptcy laws
      are changed to become much stricter and costlier. XYZ then decides to
      pay back half of its debt.
    3. A CEO named Joe Bigwig is known for living large with very expensive
      cars and a huge mansion. Joe is seeking a large loan from a bank to
      finance some new projects for his corporation. However, the bank becomes
      concerned when they find out that he recently used company funds to buy
      a brand-new company jet and also schedules numerous business trips to
      Hawaii and stays in five-star hotels. The bank tells Joe he will receive
      the loan only if he agrees to scale back on his personal expenses and
      not give himself or any other executives a raise until the loan is paid
      back.

Assignment Expectations

  • Answer the assignment questions directly.
  • Stay focused on the precise assignment questions. Do not go off on
    tangents or devote a lot of space to summarizing general background
    materials.
  • For computational problems, make sure to show your work and explain your steps.
  • For short answer/short essay questions, make sure to reference your
    sources of information with both a bibliography and in-text citations.
    See the Student Guide to Writing a High-Quality Academic Paper,
    including pages 11-14 on in-text citations. Another resource is the
    “Writing Style Guide,” which is found under “My Resources” in the TLC
    Portal.