Unit 12 Assessment — Capital Structure & Leverage

⚙️ Operating & Financial Leverage

📐 Break-Even & EBIT-EPS

🏛️ MM Theory & Tax Shield

⚖️ Trade-off & Pecking Order

Leverage Measures

Degree of Operating Leverage (DOL)DOL = Contribution Margin ÷ EBIT = (S − VC) ÷ (S − VC − FC)

Degree of Financial Leverage (DFL)DFL = EBIT ÷ (EBIT − Interest)

Degree of Combined Leverage (DCL)DCL = DOL × DFL

Contribution MarginSales − Variable Costs = Q × (P − V)

Hamada Equationβ_L = β_U × [1 + (1−T) × (D/E)]

Break-Even & EBIT-EPS

Operating Break-Even (Units)Q_BE = Fixed Costs ÷ (Price − Variable Cost)

Operating Break-Even (Sales $)BE$ = Fixed Costs ÷ Contribution Margin %

EPS under any planEPS = (EBIT − Interest) × (1 − T) ÷ Shares

EBIT Indifference PointSet EPS_Plan A = EPS_Plan B; solve for EBIT

Contribution Margin %CM% = (P − V) ÷ P

MM Theory

MM Prop I (no taxes)V_L = V_U — capital structure irrelevant

MM Prop I (with taxes)V_L = V_U + T × D (value of tax shield)

MM Prop II (no taxes)r_s rises as leverage ↑ — exactly offsets debt benefit

Tax Shield ValuePV of Tax Shield = T × D (if debt is permanent)

MM World AssumptionNo taxes, no bankruptcy costs, perfect markets

Trade-off & Pecking Order

Trade-off TheoryOptimal structure balances tax shield benefit vs. financial distress costs

Financial DistressDirect: legal/admin costs · Indirect: lost sales, key employees

Pecking Order TheoryPrefer: retained earnings → debt → new equity (last resort)

Agency CostsDebt holders vs. shareholders conflicts; monitoring costs

Signaling TheoryNew equity issue often signals overvaluation → stock price falls

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out of 100 points

—

Section 1

—/40

Multiple Choice

Section 2

—/20

True / False

Section 3

—/20

Short Answer

Section 4

—/20

Extended Response

⚠ Sections 3 & 4 are teacher-graded. Use the rubric selectors below to finalize the score.

Multiple Choice

Select the best answer · DOL, DFL, DCL, break-even, MM theory & EBIT-EPS calculations

2 pts each · 40 pts

Click the best answer. Use the formula reference panel and theory strip above. Each question is worth 2 points.

True or False

Click TRUE or FALSE for each statement

2 pts each · 20 pts

Select TRUE or FALSE for each statement. Each is worth 2 points.

Short Answer

Show all calculations + explain in 2–4 sentences · Teacher-graded

5 pts each · 20 pts

Answer in 2–4 complete sentences. Show every calculation step clearly. Rubric selectors appear after grading.

Extended Response — Bessemer Fabrication Co.: Capital Structure Advisory Memo

EBIT-EPS · Tax shield · Trade-off · Leverage recommendation · Teacher-graded

20 pts

Read the scenario carefully. Write a well-organized analytical memo of at least 8 sentences. Show all calculations with labeled steps. Use and underline at least four unit vocabulary terms.

📋 Scenario — Bessemer Fabrication Co.: Choosing an Optimal Capital Structure

Bessemer Fabrication Co. (BFC) is a Black-owned light manufacturing company in Bessemer, Alabama. BFC is growing and needs to raise $500,000 in new capital. The finance committee is evaluating two capital structure plans. The company expects EBIT of $90,000 next year. The corporate tax rate is 25%.

Plan A — All Equity

New shares issued: 20,000
Existing shares: 30,000
Total shares: 50,000
Interest expense: $0

Plan B — Debt + Equity

New debt: $300,000 @ 8%
New shares issued: 8,000
Existing shares: 30,000
Total shares: 38,000

MM Tax Shield (Plan B)

Unlevered firm value (V_U): $600,000
Tax rate (T): 25%
Debt (D): $300,000

Financial Distress Risk

BFC's industry has volatile revenues. High debt increases probability of distress. Discuss trade-off vs. tax shield benefit.

35 Write your full capital structure advisory memo covering all four parts: (a) Calculate EPS under Plan A and Plan B at the expected EBIT of $90,000 — show full formula for each plan with interest expense subtracted and taxes applied; (b) Calculate the EBIT indifference point — the EBIT level where Plan A and Plan B produce identical EPS — show your algebraic setup and solution; (c) Calculate the value of the tax shield under MM theory with corporate taxes (V_L = V_U + T × D) and explain what this number means; then describe one reason why BFC should NOT simply maximize debt to capture the full tax shield; (d) Write a 2–3 sentence recommendation to the BFC finance committee stating which plan to adopt, weighing EPS impact, the EBIT indifference point, and the trade-off between the tax shield and financial distress risk given BFC's volatile revenue environment. Use at least four underlined vocabulary terms.

📋 Teacher Scoring Rubric

Criterion	Excellent (Full)	Proficient (Partial)	Developing (Minimal)	Score
Part (a) — EPS Calculations Plan A: (90,000−0)×0.75÷50,000=$1.35 · Plan B: (90,000−24,000)×0.75÷38,000=66,000×0.75÷38,000=$49,500÷38,000=$1.303	Both EPS values correctly calculated with interest (Plan B: $300K×8%=$24K) and taxes applied; Plan A=$1.35, Plan B≈$1.30	Both plans attempted; minor arithmetic error (±$0.05); formula structure correct	Only one plan calculated or interest/tax not applied correctly	/6
Part (b) — EBIT Indifference Point (EBIT)×0.75÷50,000 = (EBIT−24,000)×0.75÷38,000 → 38,000×EBIT = 50,000×(EBIT−24,000) → 38,000×EBIT = 50,000×EBIT−1,200,000,000 → 12,000×EBIT = 1,200,000,000 → EBIT = $100,000	Algebraic setup shown correctly; EBIT* = $100,000 derived; interprets as "below $100K, Plan A gives higher EPS; above $100K, Plan B gives higher EPS"	Correct setup; arithmetic error leads to wrong EBIT*; or no interpretation given	No algebraic setup; indifference concept misunderstood	/5
Part (c) — MM Tax Shield & Trade-off V_L = $600,000 + 0.25×$300,000 = $600,000 + $75,000 = $675,000 · Tax shield = $75,000	V_L = $675,000 correctly calculated; tax shield = $75,000 explained as PV of government subsidy; one concrete financial distress cost cited (e.g., lost customers, higher borrowing costs, employee turnover)	Calculation correct; distress discussion vague or only one sentence	Formula wrong or tax shield not interpreted; no distress discussion	/5
Part (d) — Recommendation	Recommends Plan A (all equity) given volatile revenues and EBIT likely near/below $100K indifference point; acknowledges Plan B's EPS advantage at higher EBITs and the $75K tax shield but argues financial distress risk outweighs benefit for a small community manufacturer; ≥4 underlined vocabulary terms used	Defensible recommendation with some trade-off reasoning; fewer than 4 vocabulary terms	Recommendation made without connecting to calculations or theory	/4

Extended Response Total: — / 20

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Capital Structure& Leverage

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