Assessment 8 instructions: capital structure and financial health

Complete four problems evaluating optimal capital structure and the financial health of a firm, addressing optimal capital structure, break-even analysis, WACC and optimal capital structure, and cost of trade credit and bank loan.

Introduction

By successfully completing this assessment, you will demonstrate your proficiency in the course competencies through the following assessment scoring guide criteria:

• Competency 2: Evaluate the financial health of the firm.
  • Formulate the break-even analysis.
  • Calculate cost of trade credit and bank loan.
• Competency 4: Evaluate optimal capital structure.
  • Calculate the optimal capital structure.
  • Calculate the WACC and optimal capital structure.

Instructions

For this assessment, complete Problems 1–4 evaluating optimal capital structure and the financial health of a firm. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:

• You may need an HP 10B II business calculator.
• You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.
• If you choose to solve the problems algebraically, be sure to show your computations.
• If you use a financial calculator, show your input values.
• If you use an Excel spreadsheet, show your input values and formulas.

Problem 1: Optimal Capital Structure

XYZ Inc. is setting its target capital structure. The CFO of XYZ Inc. believes that the optimal debt-to-capital ratio is between 25 percent and 60 percent. Her staff derived following the projections. Various debt levels were considered.

Debt/Capital Ratio Projected EPS Projected Stock PriceDept/Capital RatioProjected EPSProjected Stock Price25%$4.20$40.0035%$4.45$41.5045%$4.75$41.2560%$4.50$40.59

Assuming that the firm uses only debt and common equity, what is XYZ’s optimal capital structure? At what debt-to-capital ratio is the company’s WACC minimized?

Problem 2: Break-Even Analysis

XYZ Inc. sells photoframes for $20 each. The fixed costs are $60,000, and variable costs are $7 per photoframe.

1. What is the firm’s gain or loss at sales of 6,000 photoframes? At 15,000 photoframes?
2. How would the break-even point be affected if the selling price was raised to $25? How is this analysis significant?
3. If the selling price was raised to $25 but variable costs rose to $13 a unit, what would happen to the break-even point?

Problem 3: WACC and Optimal Capital Structure

This problem is easiest to complete in Excel. Structure consists of only debt and common equity. XYZ’s finance department staff created the following table showing the firm’s debt cost at different debt levels:

Debt-to-Capital RatioEquity-to-Capital RatioDebt-to-Equity RatioBond RatingBefore-Tax Cost of Debt0.01.00.00A6.0%0.20.80.25BBB7.0%0.40.60.67BB9.0%0.60.41.50C11.0%0.80.24.00D14.0%

XYZ uses the CAPM to estimate its cost of common equity and estimates that the risk-free rate is 4 percent, the market risk premium is 7 percent, and its tax rate is 35 percent. XYZ estimates that if it had no debt, its “unlevered” beta would be 1.5.

1. What would be its WACC at the optimal capital structure? What would the firm’s optimal capital structure be?
2. If XYZ’s managers anticipate that the company’s business risk will increase in the future, what effect would this likely have on the firm’s target capital structure?
3. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ’s target capital structure?

Problem 4: Cost of Trade Credit and Bank Loan

XYZ Inc. buys $10 million of materials (net of discounts) on terms of 3/5, net 60, and it currently pays on the 5th day and takes discounts. XYZ plans to expand, which will mean additional financing.

1. If XYZ decides to forgo discounts, could it obtain much additional credit?
2. What would be the nominal and effective cost of that credit?
3. What would be the effective cost of the bank loan if the company could get the funds from a bank at a rate of 8 percent and if the interest was paid monthly? All of this should be based on a 365-day year.
4. Should XYZ use bank debt or additional trade credit? Explain.

Competencies Measured

By successfully completing this assessment, you will demonstrate your proficiency in the course competencies through the following assessment scoring guide criteria:

• Competency 2: Evaluate the financial health of the firm.
  • Formulate the break-even analysis.
  • Calculate cost of trade credit and bank loan.
• Competency 4: Evaluate optimal capital structure.
  • Calculate the optimal capital structure.
  • Calculate the WACC and optimal capital structure.