Question

Robert is comparing two different capital structures: An all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 205,000 shares of stock outstanding. Under Plan II, there would be 155,000 shares of stock outstanding and $3.1 million in debt outstanding. The interest rate on the debt is 8 percent, and there are no taxes. a.If EBIT is $600,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) b. If EBIT is $850,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) c. What is the break-even EBIT?

Answer 1

(a):

	Plan I	Plan II
EBIT	600,000.00	600,000.00
less: interest @ 8% of $3.1 million	-	248,000.00
Net income = EBIT - interest	600,000.00	352,000.00
EPS = Net income/no. of shares	2.93	2.27

(b):

	Plan I	Plan II
EBIT	850,000.00	850,000.00
less: interest @ 8% of $3.1 million	-	248,000.00
Net income = EBIT - interest	850,000.00	602,000.00
EPS = Net income/no. of shares	4.15	3.88

(c): Let break even EBIT be"x". EPS will be same at this level for both the capital options.

Thus x/205,000 = (x-248,000)/155,000

or 0.7561x = x-248,000

or 0.2439x = 248,000

or x = 248,000/0.2439

= $1,016,800