Mr. Kakai Manufacturing Co. Ltd has an average selling price of Sh.1000 for a component it manufactures for sale in the local market. Variable costs are Sh.700 per unit and fixed costs amount to Sh.17 million.
The company has financed its assets having issued 40,000 ordinary shares.
Another company in the same industry, Bantu Manufacturers, has the same operating information but has financed its assets with 20,000 ordinary shares and a loan, which has an interest payments of Sh.160,000 per year. Both companies are in the same 40% tax bracket and have sales of Sh.70 m in the current financial year.
(a) For each company, determining the degree of operating leverage and the degree of financial leverage.
(b) Calculate the degree of combined leverage for each firm. Explain the difference in the result.
(c) Compute the break-even points for the two companies. What are your observations?
(d) Calculate the earnings per share (EPS) at the point of indifference between the two companies earnings.
(f) Explain the position of Modigliani and Miller (MM) with respect to the use of leverage in a firm.
Bantu Ltd has a high DTL due to the presence of fixed financing costs (Ksh.160,000)
(c) Break-even pf for the two companies
BEP the quantity that must be produced and sold to meet the fixed operating costs.
Bantu Ltd has to achieve a higher BEP to cover for the additional fixed financing costs.
(d) EPS at the point of
indifference EPS is given by
EPS at the point of indifference between co. earnings is Ksh..4800.
Position of MM with respect to use of leverage (debt)
Without taxes, MM position is that debt has no effect on firm value (VL = VU)
With corporate taxes, MM position is that the levered firm commands a higher value because of the interest tax shied.
VL = VU + PV of ITS
With corporate and personal taxes, MM‟s decision is that effect of leverage depends on the tax rate.
With taxes and financial distress, MM argue is that debt (leveraged) is a two edged sword i.e it is advantageous and disadvantageous at the same time.
Advantage = in the sense that it enables tax savings
Disadvantage = reduces the value of the firm
VL = VU + PV of ITS – PV of FDC PVITS = PV of interest (tax shield)
PVFDC = PV of financial distress costs (disadvantage of debt) i.e costs that arise due to excessive use of debt.