Question

Edsel Research Labs has $29.60 million in assets. Currently half of these assets are financed with long-term debt at 6 percent and half with common stock having a par value of $10. Ms. Edsel, the Vice President of Finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). The company earns a return on assets before interest and taxes of 6 percent. The tax rate is 35 percent.

Under Plan D, a $7.40 million long-term bond would be sold at an interest rate of 12 percent and 740,000 shares of stock would be purchased in the market at $10 per share and retired. Under Plan E, 740,000 shares of stock would be sold at $10 per share and the $7,400,000 in proceeds would be used to reduce long-term debt.

a-1. How would each of these plans affect earnings per share? Consider the current plan and the two new plans. (Round your answers to 2 decimal places.)
  

Earning per Shares

Current ______

Plan D _______

Plan E ________

  
a-2. Which plan(s) would produce the highest EPS? Note that due to tax loss carry-forwards and carry-backs, taxes can be a negative number.
  

• The Current Plan and Plan E

• Plan D

• Plan E

• Current Plan

  
b. Which plan would be most favorable if return on assets increased to 9 percent? Compare the current plan and the two new plans.
  

• Plan D

• Plan Current and D

• Plan E

• Current Plan and Plan D

  
c. Assuming return on assets is back to the original 6 percent, but the interest rate on new debt in Plan D is 8 percent, which of the three plans will produce the highest EPS?
  

• The Plan Current and E

• The plans Current and D

• Plan E

• Plan D

Answer 1

	Current Plan	Plan D	Plan E
EBIT	1,776,000	1,776,000	1,776,000
Less: Interest	888,000	1,776,000	444,000
EBT	888,000	-	1,332,000
Less: Tax	310,800	-	466,200
Net Income	577,200	-	865,800
Number of shares	1,480,000	740,000	2,220,000
EPS	0.39	0.00	0.39
The Current Plan and Plan E

If 9% return
	Current Plan	Plan D	Plan E
EBIT	2,664,000	2,664,000	2,664,000
Less: Interest	888,000	1,776,000	444,000
EBT	1,776,000	888,000	2,220,000
Less: Tax	621,600	310,800	777,000
Net Income	1,154,400	577,200	1,443,000
Number of shares	1,480,000	740,000	2,220,000
EPS	0.78	0.78	0.65
The Current Plan and Plan D

	Current Plan	Plan D	Plan E
EBIT	1,776,000	1,776,000	1,776,000
Less: Interest	888,000	1,480,000	444,000
EBT	888,000	296,000	1,332,000
Less: Tax	310,800	103,600	466,200
Net Income	577,200	192,400	865,800
Number of shares	1,480,000	740,000	2,220,000
EPS	0.39	0.26	0.39
The Current Plan and Plan E