Question

Kolby Corp. is comparing two different capital structures. Plan I would result in 33,000 shares of stock and $96,000 in debt. Plan II would result in 27,000 shares of stock and $288,000 in debt. The interest rate on the debt is 5 percent.

a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $130,000. The all-equity plan would result in 36,000 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 24 percent, what is the EPS for each of the plans? (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 24 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 24 percent, when will EPS be identical for Plans I and II? (Do not round intermediate calculations.)

Answer 1

a)

Plan 1

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (130000-96000*0.05)*(1-0)/33000=3.79

Plan 2

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (130000-288000*0.05)*(1-0)/27000=4.28

All equity plan

EPS = EBIT*(1-tax rate)/shares = 130000*(1-0)/36000=3.61

b)

Plan 1

Break even EBIT is the EBIT where EPS plan I = EPS all equity

EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares

EBIT*(1-0)/36000=(EBIT-96000*0.05)*(1-0)/33000

EBIT =57600

Plan 2

Break even EBIT is the EBIT where EPS plan II = EPS all equity

EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares

EBIT*(1-0)/36000=(EBIT-0.05*288000)*(1-0)/27000

EBIT =57600

c)

EBIT level when EPS I = EPS II:

(EBIT-int. rate*debt Plan I)*(1-tax rate)/shares Plan I= (EBIT-int. rate*debt Plan II)*(1-tax rate)/shares plan II

(EBIT-0.05*96000)*(1-0)/33000=(EBIT-0.05*288000)*(1-0)/27000

EBIT =57600

d-1)

Plan 1

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (130000-96000*0.05)*(1-0.24)/33000=2.88

Plan 2

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (130000-288000*0.05)*(1-0.24)/27000=3.25

All equity plan

EPS = EBIT*(1-tax rate)/shares = 130000*(1-0.24)/36000=2.74

d-2)

Plan 1

Break even EBIT is the EBIT where EPS plan I = EPS all equity

EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares

EBIT*(1-0.24)/36000=(EBIT-96000*0.05)*(1-0.24)/33000

EBIT =57600

Plan 2

Break even EBIT is the EBIT where EPS plan II = EPS all equity

EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares

EBIT*(1-0.24)/36000=(EBIT-0.05*288000)*(1-0.24)/27000

EBIT =57600

d-3)

EBIT level when EPS I = EPS II:

(EBIT-int. rate*debt Plan I)*(1-tax rate)/shares Plan I= (EBIT-int. rate*debt Plan II)*(1-tax rate)/shares plan II

(EBIT-0.05*96000)*(1-0.24)/33000=(EBIT-0.05*288000)*(1-0.24)/27000

EBIT =57600