Question

James 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 160,000 shares of stock outstanding. Under Plan II, there would be 80,000 shares of stock outstanding and $2.8 million in debt outstanding. The interest rate on the debt is 8 percent, and there are no taxes.

Required:

(a)	If EBIT is $350,000, Plan I's EPS is $  while Plan II's EPS is $  . (Do not include the dollar signs ($). Round your answers to 2 decimal places. (e.g., 32.16))

(b)	If EBIT is $500,000, Plan I's EPS is $  and Plan II's EPS is $  . (Do not include the dollar signs ($). Round your answers to 2 decimal places. (e.g., 32.16))

(c)	The break-even EBIT is $  . (Do not include the dollar sign ($). Round your answer to the nearest whole dollar amount. (e.g., 32.))

2.

Tool Manufacturing has an expected EBIT of $60,000 in perpetuity and a tax rate of 35 percent. The firm has $115,000 in outstanding debt at an interest rate of 7.2 percent, and its unleveraged cost of capital is 10 percent.

  

What is the value of the firm according to M&M Proposition I with taxes? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)

Value of the firm

$

Answer 1

Answer to Question 1:

Plan I:

Number of shares outstanding = 160,000

Plan II:

Number of shares outstanding = 80,000
Value of Debt = $2,800,000

Interest Expense = 8.00% * $2,800,000
Interest Expense = $224,000

Answer a.

Answer b.

Answer c.

Let Breakeven EBIT be $x

Plan I:

EPS = (EBIT - Interest Expense) / Number of Shares
EPS = ($x - $0) / 160,000

Plan II:

EPS = (EBIT - Interest Expense) / Number of Shares
EPS = ($x - $224,000) / 80,000

EPS under Plan I and EPS under Plan II
($x - $0) / 160,000 = ($x - $224,000) / 80,000
$x = 2 * $x - $448,000
$x = $448,000

Breakeven EBIT is $448,000