Case 22 Cpk

1. In what ways can Susan Collyns facilitate the success of CPK?

2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? What about the cost of capital? In assessing the effect of leverage on the cost of capital, you may assume that a firm’s CAPM beta can be modeled in the following manner: L = U[1 + (1 − T)D/E], where U is the firm’s beta without leverage, T is the corporate income tax rate, D is the market value of debt, and E is the market value of equity.

3. Based on the analysis in case Exhibit 9, what is the anticipated CPK share price under each scenario? How many shares will CPK be likely to repurchase under each scenario? What role does the tax deductibility of interest play in encouraging debt financing at CPK?

4. What capital structure policy would you recommend for CPK?

Financial leverage and financial risk

We need to pay attention to the apparent appeal of leverage in increasing the expected ROE of CPK. To illustrate the point that leverage comes with additional risk, let’s adjust the earnings before interest and taxes (EBIT) line of case Exhibit 9 by a certain amount both up and down. In the first round, the EBIT line can be multiplied by a factor of −1. In this case, the no-leverage ROE drops to −18%, while the high-leverage ROE drops even more to −29%. Alternatively, if the EBIT line is multiplied by a factor of 2, the no-leverage ROE rises to +22%, while the high-leverage ROE increases even more to +30%. We should quickly see the magnifying effect of leverage on the risk of equity returns.

So should equity investors be happy with the same level of return for a much higher risk? Leverage is simply a way of slicing up the business risk. Since the weighted average cost of capital (WACC) reflects the total risk, the WACC should not change with simply slicing up the risk across various types of contracts. The total risk is unadjusted. To demonstrate this point with the...