Question

Bellwood Corp. is comparing two different capital structures. Plan I would result in 31,000 shares of stock and $93,000 in debt. Plan II would result in 25,000 shares of stock and $279,000 in debt. The interest rate on the debt is 7 percent.

  

a.	Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $120,000. The all-equity plan would result in 34,000 shares of stock outstanding. What is the EPS for each of these plans? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
b.	In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? (Do not round intermediate calculations.)
c.	Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II? (Do not round intermediate calculations.)
d-1.	Assuming that the corporate tax rate is 22 percent, what is the EPS of the firm? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
d-2.	Assuming that the corporate tax rate is 22 percent, what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? (Do not round intermediate calculations.)
d-3.	Assuming that the corporate tax rate is 22 percent, when will EPS be identical for Plans I and II? (Do not round intermediate calculations.)

Answer 1

a.

	Plan I	Plan II	All Equity Plan
EBIT	$ 120,000	$ 120,000	$ 120,000
Less : Interest Expense	(6,510)	(19,530)	0
Earnings before Taxes	113,490	100,470	120,000
Less: Taxes	0	0	0
Net Income	113,490	100,470	120,000
Number of Shares Outstanding	31,000	25,000	34,000
EPS	$ 3.66	$ 4.02	$ 3.53

b. At break-even EBIT, EPS for both options is equal.

Break-even EBIT of Plan I and All Equity Plan : $ 73,780

Let the break-even EBIT be E.

( E - 6,510 ) / 31,000 = E / 34,000

or 34,000 E - 221,340,000 = 31,000 E

or E = $ 73,780

Break-even EBIT of Plan II and All Equity Plan : $ 73,780

( E - 19,530 ) / 25,000 = E / 34,000

or 34,000 E - 664,020,000 = 25,000 E

or E = $ 73,780

c. Answer : $ 73,780

d-1:

	Plan I	Plan II	All Equity Plan
Earnings before Taxes	$ 113,490	$ 100,470	$ 120,000
Less: Taxes @ 22 %	24,968	22,103	26,400
Net Income	88,522	78,367	93,600
Number of Common Shares Outstanding	31,000	25,000	34,000
EPS	$ 2.86	$ 3.13	$ 2.75

d - 2: . Break-even level of EBIT of Plan I and All Equity Plan : $ 73,780

[ ( E - 6,510 ) x 0.78 ] / 31,000 =( E x 0.78) / 34,000

or 34,000 x ( 0.78 E - 5,077.80 ) = 31,000 x 0.78 E

or 26,520 E - 172,645,200 = 24,180 E

E = $ 73,780

Break-even level of EBIT of Plan II and All Equity Plan : $ 73,780

d-3 : EPS will be identical for Plans I and II at EBIT of $ 73,780