Reference no: EM132721156

At your company, sales and their probabilities are forecast for next year as follows: $300,000 at 25% probability; $400,000 at 50% probability; $500,000 at 25% probability. Fixed annual operating costs are expected at $150,000. Variable operating costs are pegged to operating revenue at 35% of sales. The current capital structure stands at 100% common stock (no preferred shares, no debt) at 30,000 shares and $8 per share book value. The current marketplace points to the following estimated required returns with regard to earnings per share (EPS):

Coefficient of variation of EPS:      Required Return:
0.42                                           14%
0.44                                           16%
0.45                                          18%
0.46                                          21%
0.51                                           23%
0.60                                           25%

If the company moves to change its capital structure from common stock to debt, analysts have determined that three possible debt ratios would be feasible:

(1) a debt ratio of 25% at an interest rate of all debt of 8%; (2) a debt ratio of 35% at an interest rate of all debt of 12%; and (3) a debt ratio of 55% at an interest rate of all debt of 15%. The firm's tax rate is 36%.

Problem (A) Compute the required earnings per share (EPS); the standard deviation of EPS; and the coefficient of variation of EPS for each of the three capital structures.

Problem (B) Scenario 1: If the management wants to maximize the earnings per share, identify the best capital structure of the three. Scenario 2: If the management wants to maximize share value, identify the best capital structure of the three.

Problem (C) Using Figure 12.7 as your guide, graph the results of Part B for scenarios 1 and 2. You will have only 3 data points on each graph. Compare the maximums for each scenario.