Question

Debt and financial risk   Tower Interiors has made the forecast of sales shown in the following table.

Sales Probability

$200,000 0.20

$300,000 0.60

$400,000 0.20

The firm has fixed operating costs of $75,000 and variable operating costs equal to 70% of the sales level. The company pays $12,000 in interest per period. The tax rate is 40%.

a. Compute the earnings before interest and taxes​ (EBIT) for each level of sales.

b. Compute the earnings per share​ (EPS) for each level of​ sales, the expected​ EPS, the standard deviation of the​ EPS, and the coefficient of variation of​ EPS, assuming that there are 10,000 shares of common stock outstanding.

c. Tower has the opportunity to reduce its leverage to zero and pay no interest. This will require that the number of shares outstanding be increased to 15,000. Repeat part ​(b​) under this assumption.

d. Compare your findings in parts ​(b​) and ​(c​)​, and comment on the effect of the reduction of debt to zero on the​ firm's financial risk.

Answer 1