Week 8 – Checkpoint 1 (Instructor Answer Key)

6.6
(a)
Debt

Equity

Debt Ratio*
40+10
90+10
= 50%
40
90+10
= 40%

Times Interest Earned*
18
4.8+1.5
= 2.86 x
18
4.8
= 3.75x

Operating Profit
18,000,000

18,000,000

Interest Expense 6,300,000

4,800,000

Earnings before tax
11,700,000

13,200,000

Income tax exp. (40%) 4,680,000

5,280,000

Net Income 7,020,000

7,920,000

Shares Outstanding
800,000

1,000,000

Earnings Per Share
$8.78

$7.92

Return on Equity
7,020
50,000
= 14.04%
7,920
60,000
= 13.20%

Return on Assets (adjusted)
7,020+6,300(1-0.4)
100,000
= 10.80
7,920+4,800(1-0.4)
100,000
= 10.80

Financial Leverage Index
14.04
10.80
= 1.3
13.20
10.80
= 1.2

*Numbers are in millions

(b)Use of debt would increase the debt ratios from 44% to 50%, while equity financing would reduce the debt ratio to 40%. Interest coverage would decline from 3.1 times to 2.86 times if debt is employed; times interest earned would increase to 3.75 times with stock financing. Earnings per share would be higher with the debt financing. The financial leverage index is greater than 1, indicating the successful use of financial leverage under either alternative, but is higher with debt financing.

The Board would want to consider each of these ratios and other factors as well. The additional risk resulting from adding debt would likely exert downward pressure on the price to earning ratio and thus could result in a decreased share price. The Board would want to review the reasonableness of the projection for operating profit, including the stability and predictability of the firm's earnings stream in the past. Other factors would include the marketability of stock relative to the current and future availability of credit; interest rate