Question

Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Lenow and Hall are presented here. Lenow Hall Debt @ 9% $ 190,000 Debt @ 9% $ 380,000 Common stock, $10 par 380,000 Common stock, $10 par 190,000 Total $ 570,000 Total $ 570,000 Common shares 38,000 Common shares 19,000

a. Complete the following table given earnings before interest and taxes of $23,000, $51,300, and $64,000. Assume the tax rate is 20 percent. (Negative amounts should be indicated by parentheses or a minus sign. Round your answers to 2 decimal places.)

b-1. What is the EBIT/TA rate when the firm's have equal EPS?

b-2. What is the cost of debt?

b-3. State the relationship between earnings per share and the level of EBIT.

c. If the cost of debt went up to 11 percent and all other factors remained equal, what would be the break-even level for EBIT?

Answer 1

1. EBIT/TA = Earnings before interest and taxes / Total assets

Given this equation, the answers are computed as:

= $23,000 / $570,000 = .0404, or 4.04%

= $51,300 / $570,000 = .0900, or 9.00%

= $64,000 / $570,000 = .1123, or 11.23%

EPS = (EBIT - Interest - Taxes) / Number of shares

For Lenow , the answers are computed as:

= {[$23,000 ? (.09 × $190,000)] × (1 ? .20)} / 38,000 = $.12

= {[$51,300 ? (.09 × $190,000)] × (1 ? .20)} / 38,000 = $.72

= {[$64,000 ? (.09 × $190,000)] × (1 ? .20)} / 38,000 = $.99

For Hall, the answers are computed as:

= {[$23,000 ? (.09 × $380,000)] × (1 ? .20)} / 19,000 = ?$.47

= {[$51,300 ? (.09 × $380,000)] × (1 ? .20)} / 19,000 = $.72

= {[$64,000 ? (.09 × $380,000)] × (1 ? .20)} / 19,000 = $1.25

b-1. 9%

b-2. 9%

b-3. The firm's EPS are equal when EBIT/TA is equal to the cost of debt. EBIT is at its break-even level at this point.

c. At the EBIT break-even level:

EBIT / TA = Cost of debt

EBIT = Cost of debt × TA

= .11 × $570,000

= $62,700