# Capital Structure Case

Pages: 4 (1155 words) Published: April 22, 2011
Team D

Hi everyone,   Here is our week 4 assignment. I highlighted how I propose we split up this assignment. Each section should be about 150 - 200 words.    Resource: Evaluating McGraw Industries’ Capital Structure Case in Ch. 11 of Principles of Managerial Finance Write a 350- to 700-word memo to the president of McGraw Industries that responds to questions in the case. Explain how the cost of debt, cost of equity, and weighted average cost of capital are determined. Cost of debt is simply the weighted rates of interest paid by the company on its debts. However, cost is equity is not so straightforward. The cost of equity is based on an estimate of a reasonable rate of return on the shareholders' investment. The term ‘reasonable’ is what makes all the difference. 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. A.

CurrentAB
EBIT1,200,0001,200,0001,200,000
Interest (rate x debt) 90,000 300,000 600,000 Net profits before taxes1,110,000 900,000 600,000
Taxes (T = 0.40) 444,000 360,000 240,000
Net profit after taxes 666,000 540,000 360,000

EPS 666,000/100,000 = 540,000/70,000 =360,000/40,000 =
6.667.719.00

Times Interest Earned Ratio:

CurrentAB
1,200,000/90,000 = 13.30 1,200,000/300,000 = 4.001,200,000/600,000 = 2.00

b. Prepare a single EBIT–EPS graph showing the current and two alternative capital structures. B.
EBIT – EPS Graph

10 % Debt
30 % Debt
50 % Debt

c. On the basis of the graph in part b, which capital structure will maximize McGraw’s earnings per share (EPS) at its expected level of EBIT of \$1,200,000? Why might this not be the best capital structure? On the basis of the graph in part b, the capital structure that will...