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1 Outline the characteristics that you would expect a company to have if it had
a. very low debt/equity ratio

m A low debt-to-equity ratio may also indicate that a company is not taking advantage of the inc

m Lenders and investors usually prefer low debt-to-equity ratios because their interests are bett

m Low debt-to-equity ratio suits companies operating under volatile and unpredictable business
they cannot meet in case of sudden downturns in economic activity.

b. very high debt/equity ratio

m A high debt/equity ratio generally means that a company has been aggressive in financing its
of the additional interest expense

m If the ratio is increasing, the company is being financed by creditors rather than from its own fi
investors usually prefer low debt-to-equity ratios because their interests are better protected in th

m The cost of this debt financing may outweigh the return that the company generates on the de
much for the company to handle. This can lead to bankruptcy, which would leave shareholders wi

m A high debt-to-equity ratio indicates that a company may not be able to generate enough cash
m Firms with high debt-to-equity ratios may not be able to attract additional capital.

m Availability of assets held for long-term use and not subject to drastic fluctuations in their valu
organization's apatite to sustain a higher debt-to-equity ratio because it offers better security to l
the short term (e.g. inventory) or are prone to subjective valuations (e.g. intangible assets), the o
reduced because such assets offer lesser degree of security to lenders in the event of a default.

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mpany to have if it had

ny is not taking advantage of the increased profits that financial leverage may bring.

ios because their interests are better protected in the event of a business decline.

volatile and unpredictable business environments as they cannot afford financial commitments that
tivity.

as been aggressive in financing its growth with debt. This can result in volatile earnings as a result

creditors rather than from its own financial sources which may be a dangerous trend. Lenders and
r interests are better protected in the event of a business decline.

t the company generates on the debt through investment and business activities and become too
which would leave shareholders with nothing.

ot be able to generate enough cash to satisfy its debt obligations

ract additional capital.

to drastic fluctuations in their valuation under normal conditions (e.g. buildings) increase an
because it offers better security to lenders in the event of a default. Where most assets are held in
ations (e.g. intangible assets), the organization's apatite to sustain a high debt-to-equity ratio is
lenders in the event of a default.

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What measures are currently used to indicate a company's debt capacity? Discuss c

ROI/ROCE

Debt to Total Capitalization Ratio

Gear Ratio

Debt Equity Ratio

ndicate a company's debt capacity? Discuss critically the usefulness of such measures.

m
blends in one number all major ingredients of profitability
m Can be compared with opportunities elswhere
m
Return and CE may be measued with different values
m Segment managers may ignore overall company objectives to retain high ROCEs.
m
measures the total amount of debt in a companys capital structure
m total-debt-to-capitalization ratio is a gauge of a companys financial leverage
m
a high total-debt-to-capitalization ratio can increase shareholders return on equity because
of the tax deductibility of interest payments, a higher proportion of debt reduces a companys
financial flexibility and increases the risk of insolvency.
m lower debt-to-capitalization ratio may be preferable for most companies in order to keep the
debt burden within easily manageable levels.

m a financial ratio that compares some form of owner's equity (or capital) to borrowed funds
m is a measure of financial leverage, demonstrating the degree to which a firm's activities are
funded by owner's funds versus creditor's funds.
m The higher a company's degree of leverage, the more the company is considered risky
m A company with high gearing (high leverage) is more vulnerable to downturns in the business
cycle because the company must continue to service its debt regardless of how bad sales are.
m A measure of a company's financial leverage calculated by dividing its total liabilities by
stockholders' equity.
m indicates what proportion of equity and debt the company is using to finance its assets.
m high debt/equity ratio generally means that a company has been aggressive in financing its
growth with debt

3 The Matclock Company

Net Operating earmings
Debt
Interst charge
Taxes

$10M
$20M
7%
None

a. Using the net income method and equity-capitalization rate of 12% , compute the total valu
Net operating EBI
Less: Debt Interest
Equity Profits

$
$
MV of Equity = $

10,000,000.00
(1,400,000.00)
8,600,000.00
8,600,000.00 =
0.12

MV of Debt =
Total Market Value =
Overall Capitalization Rate = $
$

10,000,000.00 =
91,666,666.67

b. Next assume that the firm issues an additional $10M in debt and uses the proceeds to repa
remain the same. Compute the new total value of the firm and overall capitalization rate.
Net operating EBI
Less: Debt Interest
Equity Profits

$
$
MV of Equity = $

10,000,000.00
(2,100,000.00)
7,900,000.00
7,900,000.00 =
0.12

MV of Debt =
Total Market Value =
Overall Capitalization Rate = $
$

10,000,000.00 =
95,833,333.33

c. Using the net operating income concept and the overall capitalization rate of 11%, compute
the implied equity-capitalization rate for the Matlock Company prior to the sale of debt.
MV of Firm = $

10,000,000.00 =
0.11

Less: MV of Debt =
MV of Equity =
Equity Capitalization Rate = $
$

8,600,000.00
70,909,090.91

d. Determine the answer to ( c) if the company were to sell the additional $10M in debt.
MV of Firm = $

10,000,000.00 =
0.11

Less: MV of Debt =
MV of Equity =
Equity Capitalization Rate = $
$

7,900,000.00
60,909,090.91

ation rate of 12% , compute the total value of the firm and the implied overall capitalization rate.

71,666,666.67

20,000,000.00

91,666,666.67
10.91%

10M in debt and uses the proceeds to repay capital; the interest rate and equity capitalization rate
he firm and overall capitalization rate.

65,833,333.33

30,000,000.00

95,833,333.33
10.43%

overall capitalization rate of 11%, compute the total market value, the market value of equity and
Company prior to the sale of debt.
$

90,909,090.91

$
$

(20,000,000.00)
70,909,090.91
12.13%

e to sell the additional $10M in debt.

$

90,909,090.91

(30,000,000.00)

60,909,090.91
12.97%

capitalization rate.

capitalization rate

alue of equity and

4 Given:
Miller Ltd
6,000,000.00
none
Distributed
Debt Securities
$
24,000,000.00
$
16,000,000.00
6,000,000.00
0.08
4.00
An investor presently owns 60,000 shares in Miller Ltd.
Expected Earning before interest
Taxes
Earnings
Activities funded by
Market Value of Equity
Market Value of Debt
Number of shares issued
Yield of Debt

a. What is the current market value of the investor's shares and what is her dollar return from

Expected Earning before interest

Interest on Debt
Equity Profits
/ Equity Capitalization Rate
Market Value of shares
Market Value of debt
Total Value of Firm

$
$
$
$
$

Overall Capitalization Rate

Debt/Equity Ratio

Miller Ltd
6,000,000.00
(480,000.00)
5,520,000.00
0.23
24,000,000.00
16,000,000.00
40,000,000.00
15.00%
66.67%

b. Show how the investor can obtain an identical dollar return at a lower net cost.
Present Earnings of Miller Ltd Shareholder

= $
$
=

5,520,000.00
24,000,000.00
55,200.00

* Therefore the amount of debt that needs to be incurred to get 'personally geared' is:
Value of Shares - Investor
Debt/Equity Ration

240,000.00
66.67%
160,000.00
12,800.00

Interest payable

*To have the same earnings as before:

New Investment earnings =
=

55,200 + 12,800
$

68,000.00

*If investment made in Modigliani Ltd.:

New Investment earnings =
* Total Value of Firm/EBI
Needed MV of shares to obtain return on
Miller

Personally Geared Debt

Selling Part of Miller Shares

68,000.00
6.67

453,333.33

$
$

160,000.00
293,333.33
453,333.33

Modigliani Ltd
6,000,000.00
none
Distributed
Equity Securities
32,000,000.00
none
5,000,000.00
none
6.40

what is her dollar return from Miller Ltd?

Modigliani Ltd
$
6,000,000.00
$
6,000,000.00
0.1875
$
32,000,000.00
$
$
32,000,000.00
18.75%
-

t a lower net cost.

'personally geared' is: