ABC is a successful winery company with a stable market share of Chinese wine in China. The sales growth rate for its Chinese wine in the coming 5 years is expected to be stagnant because of the fierce competition in the winery market and demographic decline in the number of Chinese liquor drinkers. The CEO of the company, Mr Chris Wong, is under pressure to lead the company to earn higher profits and to maximize shareholders' wealth.
In this regards, Paul Cheung, the financial analyst of the firm, was assigned by the CEO to evaluate the firm's capital structure by using scenario analysis. Currently the company contains 10% debt and 90% equity. This makes Paul realize that the company may be under-utilizing its financial leverage.
To evaluate the firm's capital structure, Paul has gathered the data summarized in the following table. He has listed out information based on the current 10% debt ratio, together with 2 alternative capital structure scenarios: Scenario 1 is 30% debt and Scenario 2 is 60% debt. The 2 scenarios are the choices which the CEO would like to consider.
Capital Structure Structure analysis
(I) Current (10% debt)
Common stock outstanding: 150000 shares
Equity required return:10%
Long term debt: $1500000
Coupon rate: 5%
(II) Scenario 1 (30% debt)
Common stock outstanding: 100500 shares
Equity required return:12%
Long term debt: $4500000
Coupon rate: 6%
(III) Scenario (60% debt)
Common stock outstanding: 40000 shares
Equity required return:16%
Long term debt: $9000000
Coupon rate: 10%
The percentage of Long Term debts in each of the 2 scenarios is based on the firm's current level of $15million total financing. The money raised by debts under both scenarios is used for repurchase of shares. The number of common stock outstanding in each scenario is determined by the CEO and presented in the table. It is expected that the firm's earnings before interest and taxes (EBIT) will be stable at its current level of $1.4million in the foreseeable future. The company is subject to the 40% tax rate.
(a) Use the current level of EBIT to calculate the times interest earned (TIE) ratio for each capital structure. Evaluate the 3 capital structure scenarios using the times interest is earned and debt ratio.
(b) Use EPS equal to zero, and EBIT equal to $1,400,000 and $900,000 to draw an EBIT-EPS graph. In your graph, please include the current and the 2 proposed capital structures. Show your EPS calculation clearly.
(c) According to your findings in part (b), which capital structure will maximize ABC's earning per shares (EPS) with its EBIT of $1,400,000? Why might this not be the best capital structure?
(d) Assume all after-tax earnings will be distributed to shareholders as dividends. Using the zero growth rate valuation model (g=0), find out the share price of ABC under of the three capital structures.
(e) On the basis of your findings in part (c) and (d), which capital structure would Paul recommend to the CEO? Why?