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. On the basis of
this scenario, the firms management has been instructed by its board to institute programs
that will allow it to operate more efficiently, earn higher profits, and, most important,
maximize share value. In this regard, the firms chief financial officer (CFO), Jon Lawson,
has been charged with evaluating the firms capital structure. Lawson believes that the current
capital structure, which contains 10% debt and 90% equity, may lack adequate financial
leverage. To evaluate the firms capital structure, Lawson has gathered the data summarized
in the following table on the current capital structure (10% debt ratio) and two alternative
capital structuresA (30% debt ratio) and B (50% debt ratio)that he would like to
consider.
Source of capital
Long-term debt
Coupon interest rate
Common stock
Required return on equity

Current (10% debt)

$1,000,000
9%
100,000 shares
12%

A (30% debt)
$3,000,000
10%
70,000 shares
13%

B (50% debt)
$5,000,000
12%
40,000 shares
18%

These structures are based on maintaining the firms current level of $10,000,000 of total
financing.
Lawson expects the firms earnings before interest and taxes (EBIT) to remain at its current
level of $1,200,000. The firm has a 40% tax rate.

Required:
a. Use the current level of EBIT to calculate the times interest earned ratio for each capital
structure. Evaluate the current and two alternative capital structures using the times interest
earned and debt ratios.
b. Prepare a single EBITEPS graph showing the current and two alternative capital
structures.
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c. On the basis of the graph in part b, which capital structure will maximize Tampas earnings
per share (EPS) at its expected level of EBIT of $1,200,000? Why might this not be the best
capital structure?
d. Using the zero-growth valuation model given in Equation 12.12, find the market value of
Tampas equity under each of the three capital structures at the $1,200,000 level of expected
EBIT.
e. On the basis of your findings in parts c and d, which capital structure would you
recommend? Why?

ANALYSIS OF KEY ISSUES

Key Issues (a): Use the current level of EBIT to calculate the times interest earned ratio for
each capital structure. Evaluate the current and two alternative capital structures using the
times interest earned and debt ratios.

Analysis: Times interest earned calculations.

Current 10% Debt

Alternative A 30%

Alternative B 50%

Debt

Debt

Debt

$1,000,000

$3,000,000

$5,000,000

Coupon rate

0.09

0.10

0.12

Interest

$ 90,000

$ 300,000

$ 600,000

EBIT

$1,200,000

$1,200,000

$1,200,000

Interest

$ 90,000

$ 300,000

$ 600,000

Times interest earned

13.33

Comment:
As the debt ratio increases from 10% to 50%, so do both financial leverage and risk. At 10%
debt and $1,200,000 EBIT, the firm has over 13 times coverage of interest payments; at 30%,
it still has 4 times coverage. At 50% debt, the highest financial leverage, coverage drops to 2
times, which may not provide enough cushions. Both the times interest earned and debt ratios
should be compared to those of the printing equipment industry.

Key Issues (b): Prepare a single EBITEPS graph showing the current and two alternative
capital structures.
EBIT

$600,000

$1,200,000

$600,000

$1,200,000

$600,000

$1,200,000

Interest

90,000

90,000

300,000

300,000

600,000

600,000

EBT

$510,000

$1,110,000

$300,0

$ 900,000

$0

$ 600,000

Taxes40%

204,00

444,000

120,000

360,000

240,000

EAT

$306,000

$ 666,00

$180,000

$ 540,000

$0

$ 360,000

EPS

$ 3.06

$ 6.66

$ 2.57

$ 7.71

$ 9.00

Current 10% Debt

Alternative A 30% Debt

Alternative B 50% Debt

100,000 Shares

70,000 Shares

40,000 Shares

Analysis: EBIT-EPS calculations (using any two EBIT levels).

Comment:
We see that the graph shows that EBIT in the X axis and EPS in the Y axis. When debt was
10% debt than EPS was $6.66 and 30% debt the EPS $7.71 and when 50% debt it shows $9.
Key Issues (c): On the basis of the graph in part b, which capital structure will maximize
Tampas earnings per share (EPS) at its expected level of EBIT of $1,200,000? Why might
this not be the best capital structure?

Analysis: If Tampa Manufacturings EBIT is $1,200,000, EPS is highest with the 50% debt
ratio. The steeper slope of the lines representing higher debt levels demonstrates that financial
leverage increases as the debt ratio increases. Although EPS is highest at 50%, the company
must also take into consideration the financial risk of each alternative. The drawback to the

EBIT-EPS approach is its emphasis on maximizing EPS rather than owners wealth. It does
not take risk into account. Also, if EBIT falls below about $750,000 (intersection of 10% and
30% debt), EPS is higher with a capital structure of 10%.

Key Issues (d): Using the zero-growth valuation model given in Equation 12.12, find the
market value of Tampas equity under each of the three capital structures at the $1,200,000
level of expected EBIT.

Analysis: Market value:

P0=EPS r s

Current: $6.66 0.12 = $55.50

Alternative A30%: $7.71 0.13 = $59.31
Alternative B50%: $9.00 0.18 = $50.0

Key Issues (e): On the basis of your findings in parts c and d, which capital structure would
you recommend? Why?
Analysis: Alternative A, 30% debt, appears to be the best alternative. Although EPS is
higher with Alternative B, the financial risk is high; times interest earned is only 2 times.
6

Alternative A has a moderate risk level, with 4 times coverage of interest earned, and
provides increased market value. Choosing this capital structure allows the firm to benefit
from financial leverage while not taking on too much financial risk.

RECOMMENDATION
From the above calculation of Tampa Manufacturing Companys debt ratio and time interest
ratio given 13.33 times, 4 times, and 2 times when debt 10%, 30% and 50% debt. So it is best
to take capital stricture alternative A because these capital structure is moderate risk for the

company and EPS is satisfactory. Though 50% debts is highest EPS and maximize owners
wealth. So company can consider alternative A capital structure.

CONCLUSION
Tampa Manufacturing Companys chose current capital structure than it earns EAT $6,
66,000 with $6.66 EPS and chose alternative A capital structure than earns $5,40,000 EAT
with $ 7.71 EPS and alternative B capital structure than earns $360000 EAT with $9 EPS.
8

Alternative A also 4 time coverage of interest earned and yester than Alternative B. it also
maximize the companys wealth than Alternative B.

REFERENCE
www.tompa.manufacturing.com/
http://users.rowan.edu/~pritchard/2008%20solutions/Gitman_IM_ch11.pdf
Principles-of-Managerial-Finance- tenth edition-by-Gitman
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Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition-by-Ross et al.

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ID

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11