Mountain Spring Example Dr. C. Bulent Aybar Professor of International Finance

Mountain Springs, Inc., bottles pure Rocky Mountain spring water and sells it through independent distributors located throughout the western and central United States. The founder of the company is a dedicated believer in the virtues of equity financing. The founder believes that Mountain Springs' 1995 earnings before interest and taxes (EBIT) of $40 million will remain relatively constant into the foreseeable future. Mountain Springs has 10 million shares of common stock outstanding, and it is traded in the over-the-counter market. The current stock price is $15, so the total value of Mountain Springs' equity is $150 million. The book value per share is also $15, so the stock now sells at its book value.

The company's financial manager, Bill Pryor, has been preaching for years that Mountain Springs should use debt in its capital structure. "After all," says Bill, "every other firm in the industry is using at least some debt, and many firms use a great deal of it. The average water company's debt-to-capital ratio is about 40 percent, and the TIE ratio is 3.5 times. I do think that the judicious use of debt would benefit everyone. Also, by being unleveraged, we are just inviting some raider to line up a lot of debt financing and then make a run at our company."

Bill, with the help of one if his former finance professors prepared the following "working" estimates for the relationship between the amount of debt used and Mountain Springs' capital costs:

If Mountain Springs recapitalizes, the borrowed funds would be used to repurchase the firm's stock in the over-the-counter market. The firm's federal-plus-state tax rate is 40 percent. Bill decided to hire your consulting company to help him analyze the situation and determine how much debt the firm should use, and to help him convince the founder to authorize a capital structure change. Bill wants you to present calculations that show Mountain Springs' stock price, number of shares remaining after recapitalization, EPS, and WACC at several debt levels. Then, if the numbers turn out as he expects, he would join you in trying to convince the founder that there is a level of debt at which the stock price would be maximized and the WACC minimized, and to persuade the founder to agree to go to that capital structure.

Basic Data Total assets $150,000 Cost of debt 14.0% EBIT $40,000 Tax rate 40% No. of shares 10,000 Probability EBIT 25% 20,000 50% 40,000 60,000

Cost of Capital Data Debt kd ks $0 16.0% 25,000 11.0% 17.0% 50,000 16.0% 25,000 11.0% 17.0% 50,000 12.0% 18.5% 75,000 14.0% 20.5% 100,000 22.0% 125,000 21.0% 26.0%

The Impact of Leverage on ROE All Equity 50% Debt Probability 0.25 0.50 EBIT $20,000 $40,000 $60,000 Interest 10,500 ----------- EBT $9,500 $29,500 $49,500 Taxes 8,000 16,000 24,000 3,800 11,800 19,800 Net Income $12,000 $24,000 $36,000 $5,700 $17,700 $29,700 =========== ROE 8.0% 16.0% 24.0% 7.6% 23.6% 39.6% TIE n.a. 1.90 3.81 5.71 E(ROE) Std dev ROE 5.7% 11.3% CV 0.35 0.48

Debt and EPS Debt EBIT Interest EBT Tax NI EPS 25,000 50,000 75,000 100,000 125,000 EBIT 40,000 Interest 2,750 6,000 10,500 17,000 26,250 EBT 37,250 34,000 29,500 23,000 13,750 Tax 14,900 13,600 11,800 9,200 5,500 NI 22,350 20,400 17,700 13,800 8,250 EPS 2.66 2.97 3.31 3.58 4.08

Leverage, WACC, Stock Price and EPS D/V Price WACC # Shares EPS $0 $150,000 150,000 0% $15.00 16.0% 10,000 $2.40 25,000 131,471 156,471 16% 15.65 15.3% 8,402 2.66 50,000 110,270 160,270 31% 16.03 15.0% 6,880 2.97 75,000 86,341 161,341 46% 16.13 14.9% 5,351 3.31 100,000 62,727 162,727 61% 16.27 14.7% 3,855 3.58 125,000 31,731 156,731 80% 15.67 2,025 4.08 (1) E = ($40 - 0.11($25))(0.6)/0.17 = $131,470,588. (2) V = $131,470,588 + $25,000,000 = $156,470,588. (3) P = ($156,470,588 - $0)/10,000,000 = $15.65. (4) n1 = 10,000,000 - ($25,000,000/$15.65) = 8,402,256.