Question

Kolby Corp. is comparing two different capital structures. Plan I would result in 9,000 shares of stock and $80,000 in debt. Plan II would result in 7,500 shares of stock and $120,000 in debt. The interest rate on the debt is 8 percent.

a.

Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $50,000. The all-equity plan would result in 12,000 shares of stock outstanding. What is the EPS for each of these plans? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

	EPS
Plan I	$
Plan II	$
All equity	$

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.)

	EBIT
Plan I and all-equity	$
Plan II and all-equity	$

c.	Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II? (Do not round intermediate calculations.)

  

EBIT

$

  

d-1	Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)

	EPS
Plan I	$
Plan II	$
All equity	$

d-2	Assuming that the corporate tax rate is 40 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.)

	EBIT
Plan I and all-equity	$
Plan II and all-equity	$

d-3	Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II? (Do not round intermediate calculations.)

EBIT

$

Answer 1

a)

Plan 1

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (50000-80000*0.08)*(1-0)/9000=4.84

Plan 2

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (50000-120000*0.08)*(1-0)/7500=5.39

All equity plan

EPS = EBIT*(1-tax rate)/shares = 50000*(1-0)/12000=4.17

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)/12000=(EBIT-80000*0.08)*(1-0)/9000

EBIT =25600

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)/12000=(EBIT-0.08*120000)*(1-0)/7500

EBIT =25600

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-0.08*80000)*(1-0)/9000=(EBIT-0.08*120000)*(1-0)/7500

EBIT =25600

d-1

Plan 1

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (50000-80000*0.08)*(1-0.4)/9000=2.91

Plan 2

EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (50000-120000*0.08)*(1-0.4)/7500=3.23

All equity plan

EPS = EBIT*(1-tax rate)/shares = 50000*(1-0.4)/12000=2.5

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*(1-0.4)/12000=(EBIT-80000*0.08)*(1-0.4)/9000

EBIT =25600

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*(1-0.4)/12000=(EBIT-0.08*120000)*(1-0.4)/7500

EBIT =25600

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-0.08*80000)*(1-0.4)/9000=(EBIT-0.08*120000)*(1-0.4)/7500

EBIT =25600