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Case 10

Aspeon Sparkling Water, Inc.

Capital Structure Policy

CASE INFORMATION

Purpose

This case, which in all aspects is identical to Case 9, illustrates the capital structure decision for a firm that starts with zero debt. Either Case 9 or Case 10, but not both, should be assigned. The primary analytical tool is valuation analysis, although the case briefly introduces the Modigliani and Miller (MM) with corporate taxes and Miller models. The case also illustrates financial risk by looking at the impact of leverage on ROE.

Time Required

The case requires 3-4 hours of preparation, plus an additional hour if the case has to be handed in.

Complexity

B--intermediate complexity.

Flexibility

The case illustrates many of the concepts associated with the use of debt financing, and hence provides an ideal vehicle for summarizing that section of the course.

MODEL INFORMATION

Description

The case model (filename CASE-10I) has two major sections. The first section constructs partial income statements to illustrate the effect of financial leverage on ROE, while the second part conducts the valuation analysis, where stock price, EPS, and WACC are calculated on the basis of capital cost relationships. The INPUT DATA and KEY OUTPUT sections are shown below:

INPUT DATA: KEY OUTPUT:

Operating Data: Impact on ROE:

Total assets $120,000,000 All equity:
Cost of debt 13.0% Expected ROE 16.0% EBIT $32,000,000 SD of ROE 7.8% Tax rate 40%
No. of shares 10,000,000 50/50 mix:
Expected ROE 24.2% Capital Cost Data: SD of ROE 15.6% D kd Valuation Analysis:
----------- -------
$0 0 D P 25,000,000 10.0% ----------- ------- 50,000,000 11.0% $0 $12.00 75,000,000 13.0% 25,000,000 13.23 100,000,000 16.0% 50,000,000 14.09 125,000,000 20.0% 75,000,000 14.53 100,000,000 14.57 D ks 125,000,000 14.12 ----------- -------

$0 16.0%
25,000,000 16.5%
50,000,000 17.5%
75,000,000 19.0%
100,000,000 21.0%
125,000,000 26.0%

Model Use

The model can be used to gain insights into the capital structure decision. For this purpose, we assign the Lotus parts of question 7.

CASE SOLUTION

Note: Our answers were calculated using the Lotus model. Students' answers obtained with a calculator may vary from those given here because of rounding errors.

Summary of Numerical Answers

2. (Dollars in Thousands)
All Equity 50% Debt
___________________________ ___________________________
EBIT $10,000 $32,000 $54,000 $10,000 $32,000 $54,000

a.Net income 6,000 19,200 32,400 1,320 14,520 27,720

b.ROE 5.0% 16.0% 27.0% 2.2% 24.2% 46.2%
TIE n.a. n.a. n.a. 1.28 4.10 6.92

c.E(ROE) 16.0% 24.2%
Std dev (ROE) 7.8% 15.6%
CV .49 .64

4. D a. Price b. # Shares
$ 0 $12.00...
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