Current10% Deb Alternative A 20% Debt Alternative B50% Debt

Debt $1,000,000 $3,000,000 $5,000,000

Coupon rate .09 .10 .12  

Interest $90,000 $300,000 $600,000

EBIT $1,200,000 $1,200,000 $1,200,000

Tampa Manufacturing, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm’s board has instructed its management to institute programs that will allow it to operate more efficiently, earn higher profits, and, most importantly, maximize share value. In this regard, the firm’s chief financial officer, Jon Lawson, has been charged with evaluating the firm’s capital structure. Lawson believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital structure, Lawson has gathered the data summarized in the attached table on the current capital structure (10% debt ratio) and two alternative capital structures – A (30% debt ratio) and B (50% debt ratio) – that he would like to consider.

Lawson expects the firm’s earnings before interest and taxes to remain at its current level of $1,200,000. The firm has a 40% tax rate.

Respond to the following:

1) 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.

2) Which capital structure will maximize Tampa’s EPS at its expected level of EBIT of $1,200,000? Why might this not be the best capital structure?

3) Using the zero-growth valuation model, find the market value of Tampa’s equity under each of the three capital structures at the $1,200,000 level of expected EBIT.