Copybold Corporation
Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share

-Refer to Copybold Corporation.What is the difference between the EPS forecasts for Feast and Famine under the conservative capital structure?
A) $1.00
B) $0.80
C) $2.20
D) $0.44
E) $0

Question

Copybold Corporation
Copybold Corporation is a start-up firm considering two alternative capital structures⎯one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share

-Refer to Copybold Corporation.What is the difference between the EPS forecasts for Feast and Famine under the conservative capital structure?
A) $1.00
B) $0.80
C) $2.20
D) $0.44
E) $0

Quizplus · Accepted Answer

Under the conservative capital structure, total debt would be $100,000 (0.25 x $400,000), while under the aggressive capital structure, it would be $300,000 (0.75 x $400,000).

Feast scenario:
- Conservative capital structure:
Interest expense = $100,000 x 10% = $10,000
EBT = $60,000 - $10,000 = $50,000
Taxes = 0.4 x $50,000 = $20,000
Net income = $30,000
EPS = $30,000 / (0.75 x 10,000) = $4.00

- Aggressive capital structure:
Interest expense = $300,000 x 12% = $36,000
EBT = $60,000 - $36,000 = $24,000
Taxes = 0.4 x $24,000 = $9,600
Net income = $14,400
EPS = $14,400 / (0.75 x 10,000) = $1.92

Famine scenario:
- Conservative capital structure:
Interest expense = $100,000 x 10% = $10,000
EBT = $20,000 - $10,000 = $10,000
Taxes = 0.4 x $10,000 = $4,000
Net income = $6,000
EPS = $6,000 / (0.75 x 10,000) = $0.80

- Aggressive capital structure:
Interest expense = $300,000 x 12% = $36,000
EBT = $20,000 - $36,000 = -$16,000
Taxes = 0
Net income = -$16,000
EPS = N/A (negative)

The difference between the EPS forecasts for Feast and Famine under the conservative capital structure is:
$4.00 - $0.80 = $3.20

Therefore, the correct answer is:
Answer: A
 The best choice is the conservative capital structure because it leads to a higher EPS under either scenario. Under the Feast scenario, EPS is $4.00 under the conservative capital structure and $1.92 under the aggressive capital structure. Under the Famine scenario, EPS is $0.80 under the conservative capital structure and negative under the aggressive capital structure. Therefore, the conservative capital structure is less risky and more beneficial to the firm.

Copybold Corporation Copybold Corporation Is a Start-Up Firm Considering Two Alternative Capital