Question

Walston waterbed works Inc. has an EBIT $2.75 million, can borrow at 15% interest, and pays combined state and federal income taxes of 40%. It currently has no debt and is capitalized by equity of $12 million. The firm has 1.5 million shares of common stock outstanding that trade at book value.

A.) Calculate Watson’s net income, ROE, and EPS currently and at capital structures that have 20%,40%, 60% and 80% debt.

B.) Compare the EPS at the different leverage levels, and the amount of charge between levels as leverage increase. What happens to the effect of more debt as leverage increase from a little to a lot?

Answer 1

Solution:-
A)	Income Statement
	Particulars	All equity	20% Debt	40%Debt	60% Debt	80% Debt
	EBIT	$2,750,000.00	$2,750,000.00	$2,750,000.00	$2,750,000.00	$2,750,000.00
	Less:- Interest	$0.00	$360,000.00	$720,000.00	$1,080,000.00	$1,440,000.00
	EBT	$2,750,000.00	$2,390,000.00	$2,030,000.00	$1,670,000.00	$1,310,000.00
	Less:-Tax	$1,100,000.00	$956,000.00	$812,000.00	$668,000.00	$524,000.00
	EAT	$1,650,000.00	$1,434,000.00	$1,218,000.00	$1,002,000.00	$786,000.00
	Balance sheet
	Debt	$0.00	$2,400,000.00	$4,800,000.00	$7,200,000.00	$9,600,000.00
	Equity	$12,000,000.00	$9,600,000.00	$7,200,000.00	$4,800,000.00	$2,400,000.00
	Total capital	$12,000,000.00	$12,000,000.00	$12,000,000.00	$12,000,000.00	$12,000,000.00
	Total number of share @8 per share	1,500,000.00	1,200,000.00	900,000.00	600,000.00	300,000.00
1)	ROE= EAT/Equity	13.75%	14.94%	16.92%	20.88%	32.75%
2)	EPS= EAT/No of shares	$1.10	$1.20	$1.35	$1.67	$2.62
B)	Increase in EPS as compared to previous leverage	NA	$0.10	$0.16	$0.32	$0.95
	As the amount of debt increases the ROE as well as EPS increases. Due to the effect of increase of leverage from small to large , the Eps increases by almost twice.
	Note 1:- Interest amount = Amount of debt under each option *15%
	Note2:- Price of share = Total value / Number of shares = 12 million/1.5 million= $8
	Please feel free to ask if you have any query in the comment section.