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Assignment No.

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1. What is financial distress? How does it affect the value of the firm? Ans 1: A condition where a company cannot meet or has difficulty paying off its financial obligations to its creditors. The chance of financial distress increases when a firm has high fixed costs, illi uid assets, or re!enues that are sensiti!e to economic downturns. A company under financial distress can incur costs related to the situation, such as more expensi!e financing, opportunity costs of pro"ects and less producti!e employees. The firm#s cost of borrowing additional capital will usually increase, ma$ing it more difficult and expensi!e to raise the much needed funds. %n an effort to satisfy short-term obligations, management might pass on profitable longer-term pro"ects. &mployees of a distressed firm usually ha!e lower morale and higher stress caused by the increased chance of ban$ruptcy, which would force them out of their "obs. 'uch wor$ers can be less producti!e when under such a burden. (. Explain the EBIT-E ! approach in determinin" a firm#s capital structure. Ans $% The &)%T-&*' capital structure approach focuses on finding a capital structure with the highest &*' +earnings per share, o!er the expected range of &)%T +earnings before interest and taxes,. The reason why we are interested in finding a capital structure, which will permit maximi-ation of the &*' o!er the expected range of &)%T, is because it partially helps us to achie!e the ultimate ob"ecti!e of the enterprise. The ultimate ob"ecti!e of the enterprise is to maximi-e shareholders. wealth by maximi-ing its stoc$ price. Two $ey !ariables that affect stoc$ price are return +earnings attributed to owners of the enterprise, and ris$ +which can be measured by re uired return +rs,. This approach explicitly considers maximi-ation of returns +&*',. /owe!er, it is important to note that this approach ignores ris$ +does not explicitly consider ris$,.

&a'or shortcomin" of the EBIT-E ! approach The fact that this approach fails to explicitly consider ris$ is the ma"or shortcoming of this method. As firm obtains more debt +its financial le!erage increases,, the ris$ also increases and shareholders will re uire higher returns to compensate for the increased financial ris$. Therefore, this approach is not completely appropriate because it does not consider one of the $ey !ariables +ris$,, which is necessary for maximi-ation of shareholders. wealth.

(onsiderin" financial ris) As per abo!e, the approach does not explicitly consider financial ris$. /owe!er, when utili-ing the approach, financial ris$ can be considered in two ways: 1, The approach measures financial ris$ by the financial brea$e!en point. The higher the brea$e!en point the greater the financial ris$. (, The approach also measures the financial ris$ by the slope of the capital structure line. The steeper the capital structure line the greater the financial ris$. EBIT-E ! "raph %t is a graphical approach. &*' is plotted on the !ertical axis +x-axis, and &)%T on the hori-ontal axis +y-axis,. )y connecting the coordinates for different capital structures +different !ariations of e uity !ersus debt,, capital structure lines for each capital structure are graphed. 0e will need to represent &)%T-&*' coordinates +capital structure lines, for different capital structures to ascertain at which le!els of &)%T which capital structure is preferred. This will allow us to find a capital structure with the highest &*' o!er the expected range of &)%T. 1or the purposes of this article it is sufficient to mention that to find &)%T-&*' coordinates we can assume particular &)%T !alues +and associated earnings a!ailable for common stoc$holders !alues, and calculate &*' in line with such !alues for different capital structures. The formula to calculate E ! is as follows% &*' 2 &arnings A!ailable for 3ommon 'toc$holders4 Number of 'hares of 3ommon 'toc$ 5utstanding Another easy way to find one of the &)%T-&*' coordinates is to use the financial brea$e!en point calculation. 1inancial brea$-e!en point occurs at the le!el of &)%T +earnings before interest and taxes, at which &*' +earnings per share, e uals -ero. At this le!el of &)%T all fixed financial costs are co!ered. The formula for calculation of the financial brea$-e!en point is as follows: 1inancial brea$-e!en point 2 % 6 *'741-T

Where% I * interest char"es !+ * preferred stoc) dividends

T * tax rate This capital structure approach does N5T allow us to determine the point where weighted a!erage cost of capital is at a minimum and where stoc$ price is at a maximum +where wealth of the owners of the firm is maximi-ed,. The approach focuses on maximi-ing earnings rather than on maximi-ing wealth. Therefore, although it is helpful to use when analy-ing alternati!e capital structures, the ma"or shortcoming of this approach should be ta$en into account.

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