Question

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:

Answer 1

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