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

2. 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.

3. 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."

4. 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:

5. 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.

6. 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

7. 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%

8. 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

9. 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

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