Question

Hale Corporation 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 190,000 shares of stock outstanding. Under Plan II, there would be 140,000 shares of stock outstanding and $2.8 million in debt outstanding. The interest rate on the debt is 6 percent and there are no taxes. If EBIT is $275,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) If EBIT is $525,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) What is the break-even EBIT? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Answer 1

	Plan 1                   (Fully equity)	Plan 2      (Debt)
EBIT (Earning before interest and Tax)	$        275,000	$        275,000
Less: Interest (2800000*6%)		$        168,000
EBT (Earning before Tax)	$        275,000	$        107,000
Less: Income Tax expense (If any)	$                    -	$                    -
Net Income	$        275,000	$        107,000
Divided by: Numbers of shares outstanding	190,000	140,000
EPS (Earnings per Share)	$               1.45	$               0.76
	Plan 1                   (Fully equity)	Plan 2      (Debt)
EBIT (Earning before interest and Tax)	$        525,000	$        525,000
Less: Interest (2800000*6%)		$        168,000
EBT (Earning before Tax)	$        525,000	$        357,000
Less: Income Tax expense (If any)	$                    -	$                    -
Net Income	$        525,000	$        357,000
Divided by: Numbers of shares outstanding	190,000	140,000
EPS (Earnings per Share)	$               2.76	$               2.55

What is the break-even EBIT?

EPS under Fully Equity = EBIT/190000

EPS under Debt = (EBIT-interest)/140000

Break-even EBIT means Level of EBIT where EPS is the same under both options.

Comparison of both EPS equation

EBIT/190000 = (EBIT-interest)/140000

140000* EBIT/190000 = (EBIT-interest)

EBIT * (140000 /190000) = (EBIT-interest)

EBIT * (14 /19) = (EBIT-interest)

Interest = 168000

EBIT * (14 /19) = (EBIT-168000)

EBIT * 0.7368421 = (EBIT-168000)

0.7368421EBIT = EBIT-168000

168000 = EBIT -0.7368421EBIT

168000 = 0.2631579EBIT

168000/0.2631579 = EBIT

EBIT = 168000/0.2631579 = 638400

Break-even EBIT = 638400

Let's Prove that EBIT 638400 is Breakeven EBIT
	Plan 1                   (Fully equity)	Plan 2      (Debt)
EBIT (Earning before interest and Tax)	$        638,400	$        638,400
Less: Interest (2800000*6%)		$        168,000
EBT (Earning before Tax)	$        638,400	$        470,400
Less: Income Tax expense (If any)	$                    -	$                    -
Net Income	$        638,400	$        470,400
Divided by: Numbers of shares outstanding	190,000	140,000
EPS (Earnings per Share)	$               3.36	$               3.36