Fin 508 Assignment Week 6

Fin 508 Assignment Week 6 ____________________________

Analyze various corporate finance scenarios involving capital structure decisions, project valuations, and probability assessments based on EBIT, debt, equity, and tax considerations. Provide calculations, explanations, and recommendations for each case, supported by credible references and proper formatting.

Paper For Above instruction

Corporate finance decisions regarding capital structure, financing methods, and project valuation are crucial for optimizing firm value and minimizing financial distress risks. The scenarios provided involve complex calculations and probability assessments that require a thorough understanding of financial principles, such as leverage, cost of capital, and risk analysis.

Introduction

In the contemporary corporate environment, firms face numerous strategic decisions about how to finance their operations and growth initiatives. These decisions directly impact shareholder value, risk profiles, and the company's ability to meet debt obligations. This paper explores several scenarios involving debt and equity financing, project valuation, probability of default, and optimal capital structure adjustments, illustrating the application of theoretical principles to practical situations.

Analysis of Kerry Corporation's Financing Choice

The first scenario involves Kerry Corporation's decision to raise $30 million through bonds or equity issuance. The critical EBIT level, where debt and equity financing yield equal earnings per share (EPS), guides this choice. Calculations indicate that the critical EBIT (E) is $38.1 million, derived using the formula E = I + r(NP + F), where current interest payments and new debt costs are considered. Since the expected EBIT of $50 million exceeds E*, bond financing is preferred, as it can leverage existing debt advantages.

To assess the confidence in this decision, a z-score is computed: z = (E* - EBIT) / standard deviation of EBIT, which equals -0.595. The probability of making the correct choice is the area under the normal distribution curve to the right of z = -0.595, approximately 72.41%, indicating a relatively high confidence level.

Clinton Company's Default Risk Analysis

Next, Clinton Company’s default probability when paying interest, sinking fund, and preferred dividends is analyzed. The minimal EBIT required just to cover these obligations is calculated as $12 million, which results from the equation (EBIT – I)(1 – t) – SF – PD = 0. Using the expected EBIT of $15 million with a standard deviation of $10 million, a z-score of -0.2661 is derived, indicating the company's EBIT is comfortably above the minimum threshold. The probability of default, or inability to meet obligations, is approximately 39.51%, calculated via standard normal distribution tables and verified through Excel functions.

Rice Corporation's Earnings and Share Price Valuation

For Rice Corporation, the EBIT and stock price are derived based on given debt costs, dividend payout ratio, and share count. Using the provided formulas, the EBIT is $56.947 million, and the stock price is calculated at $10.00. These calculations integrate the impact of debt, taxes, and dividends on earnings, demonstrating how leverage influences firm profitability and per-share valuation.

Powell Corporation’s Capital Raising Decision

Powell Corporation faces a decision to raise $20 million via new stock or bonds. The critical EBIT to favor equity issuance is $8.45 million, derived using the formula E = I + r(NP + F). Since the expected EBIT of $6 million is below E, the analysis recommends issuing new stock, supported by a probability assessment of approximately 68.79% that the firm will generate sufficient EBIT for favorable financing decision outcomes.

Albright Company's Financing Strategy and EPS Maximization

Albright Company compares bond and stock financing, calculating EPS for each scenario. The results favor stock issuance, with EPS(stock) at $0.7368 versus EPS(bond) at $0.70. The critical EBIT is determined as $2.85 million, and the probability of correctly choosing stock financing is approximately 80.23%, indicating that maximizing EPS aligns with stock financing in this case.

Adjusting Debt Levels for Optimal Capital Structure

Baker Company's effort to increase leverage from 40% to 42% involves selling bonds and repurchasing stock. The calculation yields that the company should issue approximately $6.97 million in bonds to achieve the new debt ratio, considering tax benefits and bankruptcy cost implications. This strategic move highlights the delicate balance between leverage and financial distress costs.

Share Buyback Impact on Bankruptcy Costs and Firm Value

Schultz Company's share repurchase aims to increase leverage but incurs additional bankruptcy costs. Equations modeling debt-to-assets ratios and firm value before and after buyback reveal a decrease in total firm value from $385 million to $350 million, with the share price dropping from $20 to approximately $19.64. This analysis underscores the risks associated with aggressive leverage and stock repurchases.

Optimal Debt-Asset Ratio Adjustment and Debt Issuance

Kissinger Company’s goal to reduce the debt/assets ratio from 30% to 25% involves selling bonds worth approximately $6.97 million. The calculation considers tax shields and bankruptcy cost reductions, illustrating how firms can optimize capital structure by balancing debt costs and financial distress risks.

Conclusion

Strategic capital structure decisions significantly influence a firm's financial health, risk profile, and shareholder value. Through detailed calculations and probability assessments, firms can better understand the implications of debt and equity choices, optimize leverage ratios, and mitigate default risks. These scenarios emphasize the importance of integrating financial theory with analytical skills to achieve optimal corporate finance outcomes.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Damodaran, A. (2015). Applied Corporate Finance (4th ed.). Wiley.
  • Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
  • Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243.
  • Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297.
  • Lintner, J. (1956). Distribution of incomes of corporations among dividends, retained earnings, and taxes. The American Economic Review, 46(2), 97-113.
  • Higgins, R. C. (2012). Analysis for Financial Management (10th ed.). McGraw-Hill Education.
  • Fama, E. F., & French, K. R. (2002). The equity premium. Journal of Finance, 57(2), 637-659.
  • Myers, S. C. (2001). Capital structure. Journal of Economic Perspectives, 15(2), 81-102.

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