Faulkner's Fine Fries, Inc. (FFF), is thinking about reducing its debt burden. Given the following capital structure information and an expected EBIT of $50 million (plus or minus 10 percent) next year, should FFF change their capital structure?
Current Porfolio
Total assets $750 million $750 million
Debt $450 million $300 million
Equity $300 million $450 million
Common stock price $30 $30
Number of shares $10,000,000 $15,000,000
Interest rate 12% 12%
Faulker’s fine fries,Inc.(FFF), is thinking about reducing its debt burden. Given the following capital structure information and an expected EBIT of $50 million(plus or minus10 percent) next year, should FFF change their capital structure?
To determine whether FFF should change their capital structure, we need to evaluate the impact of reducing their debt burden on their financial metrics. One way to do this is by assessing the effect on their earnings per share (EPS) and return on equity (ROE).
First, let's calculate the current EPS and ROE for FFF:
1. Calculate Earning Before Interest and Taxes (EBIT):
EBIT = Expected EBIT * (1 ± EBIT variation)
EBIT = $50 million * (1 ± 10%) = $55 million to $45 million
2. Calculate Net Income:
Net Income = EBIT - Interest Expense
Net Income = EBIT - (Debt * Interest Rate)
For the current capital structure:
Net Income = EBIT - ($450 million * 12%)
Net Income = EBIT - $54 million
3. Calculate EPS:
EPS = Net Income / Number of Shares
For the current capital structure:
EPS = ($55 million - $54 million) / $10,000,000
EPS = $1 / share
4. Calculate ROE:
ROE = Net Income / Equity
For the current capital structure:
ROE = ($55 million - $54 million) / $300 million
ROE = 0.0033 or 0.33%
Now, we need to perform the same calculations for the proposed capital structure with reduced debt:
1. Calculate Net Income:
For the proposed capital structure:
Net Income = EBIT - ($300 million * 12%)
Net Income = EBIT - $36 million
2. Calculate EPS:
For the proposed capital structure:
EPS = ($55 million - $36 million) / $10,000,000
EPS = $1.9 / share
3. Calculate ROE:
For the proposed capital structure:
ROE = ($55 million - $36 million) / $450 million
ROE = 0.0422 or 4.22%
By comparing the current and proposed EPS and ROE, we can assess the impact of reducing the debt burden.
For the current capital structure, EPS is $1/share, and ROE is 0.33%.
For the proposed capital structure, EPS increases to $1.9/share, and ROE increases to 4.22%.
Based on these calculations, it appears that reducing the debt burden would improve FFF's financial performance. Therefore, it may be advisable for FFF to change their capital structure by reducing their debt. However, other factors such as cash flow, cost of equity, and risk tolerance should also be considered before making a final decision.