Question

Kolby corporation is comparing two different capital structures, Plan I, would result in 1,300 shares of stock and $80,640 in debt. Plan II would result in 2,900 shares of stock and $19,200 in debt. The interest rate on the debt is 10%.

a. Ignoring taxes, compare both of these plans to an equity plan assuming that EBIT will $10,500. The all equity plan would result in 3,400 shares of stock outstanding. Which of the three plans has the highest EPS? and which one with the lowest?

b. In part (a) what are the break-even levels of EBIT for each plan as compared to that for all equity plan? Is one higher than the other? Why?

c. Ignoring taxes, when will EPS be identical for Plan I and Plan II?

Answer 1

a)

Plan 1

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (10500-80640*0.1)*(1-0)/1300=1.87 ... lowest

Plan 2

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (10500-19200*0.1)*(1-0)/2900=2.96

All equity plan

EPS = EBIT*(1-tax rate)/shares = 10500*(1-0)/3400=3.09 ... Highest

b)

Plan 1

Break even EBIT is the EBIT where EPS plan I = EPS all equity

EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares

EBIT*(1-0)/3400=(EBIT-80640*0.1)*(1-0)/1300

EBIT =13056

Plan 2

Break even EBIT is the EBIT where EPS plan II = EPS all equity

EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares

EBIT*(1-0)/3400=(EBIT-0.1*19200)*(1-0)/2900

EBIT =13056

c)

EBIT level when EPS I = EPS II:

(EBIT-int. rate*debt Plan I)*(1-tax rate)/shares Plan I= (EBIT-int. rate*debt Plan II)*(1-tax rate)/shares plan II

(EBIT-0.1*80640)*(1-0)/1300=(EBIT-0.1*19200)*(1-0)/2900

EBIT =13056