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EBIT—EPS and capital structure   ​Data-Check is considering two capital structures. The key information is shown in...

EBIT—EPS and capital structure   ​Data-Check is considering two capital structures. The key information is shown in the following table. Assume a 21% tax rate.

Source of capital    Structure A    Structure B

​Long-term debt    $98,000 at 15.6% coupon rate $196,000 at 16.6% coupon rate

Common stock 4,800 shares    2,400 shares

a. Calculate two ​EBIT-EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values.

b. Plot the two capital structures on a set of​ EBIT-EPS axes.

c. Indicate over what EBIT​ range, if​ any, each structure is preferred.

d. Discuss the leverage and risk aspects of each structure.

e. If the firm is fairly certain that its EBIT will exceed $72,000​, which structure would you​ recommend? Why? What if the tax rate was​ higher, say​ 40%?

a. Calculate two ​EBIT-EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values.

Complete the tables below using $50,000 and $60,000 ​EBIT:

Solutions

Expert Solution

a.

Structure A Structure B
EBIT 50000 60000 50000 60000
Less- Interest 15288 15288 32536 32536
Net profits before taxes 34712 44712 17464 27464
Less- Taxes @ 21% 7289.52 9389.52 3667.44 5767.44
Net profits after taxes 27422.48 35322.48 13796.56 21696.56
EPS (4800 shares) 5.71 7.36
EPS (2400 shares) 5.75 9.04
Financial break-even points
Structure A Structure B
15288 32536

b

c.

c.

If EBIT is expected to be below $49,784, Structure A is preferred. If EBIT is expected to be above $49,784, Structure B is preferred.

d.

Structure A has less risk and promises lower returns as EBIT increases. B is more risky since it has a higher financial break-even point. The steeper slope of the line for Structure B also indicates greater financial leverage.

e.

If EBIT is greater than $72,000, Structure B is recommended since changes in EPS are much greater for given values of EBIT.

Structure A Structure B
EBIT 50000 60000 50000 60000
Less- Interest 15288 15288 32536 32536
Net profits before taxes 34712 44712 17464 27464
Less- Taxes @ 40% 13884.8 17884.8 6985.6 10985.6
Net profits after taxes 20827.2 26827.2 10478.4 16478.4
EPS (4800 shares) 4.34 5.59
EPS (2400 shares) 4.37 6.87

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