Question

Destin Corp. is comparing two different capital structures. Plan I would result in 10,000 shares of stock and $100,000 in debt. Plan II would result in 5,000 shares of stock and $200,000 in debt. The interest rate on the debt is 6 percent.

  

a.	Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $60,000. The all-equity plan would result in 15,000 shares of stock outstanding. What is the EPS for each of these plans? (Round your 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?

  

	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?

  

EBIT

$

  

d-1	Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm? (Round your 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?

  

	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?

  

EBIT	$    HOW TO SOLVE d-2 and d-3

Answer 1

Plan 1:

Number of shares = 10,000
Value of Debt = $100,000

Interest Expense = 6% * $100,000
Interest Expense = $6,000

Plan II:

Number of shares = 5,000
Value of Debt = $200,000

Interest Expense = 6% * $200,000
Interest Expense = $12,000

All Equity Plan:

Number of shares = 15,000

Answer a.

Answer b.

Plan I and All-equity:

Let breakeven EBIT be $x

Plan I:

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $6,000) / 10,000

All Equity Plan:

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $0) /15,000

EPS Plan I = EPS all Equity Plan
($x - $6,000) / 10,000 = $x / 15,000
3*$x - $18,000 = 2*$x
$x = $18,000

So, Breakeven EBIT is $18,000

Plan II and All-equity:

Let breakeven EBIT be $x

Plan II:

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $12,000) / 5,000

All Equity Plan:

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $0) /15,000

EPS Plan I = EPS all Equity Plan
($x - $12,000) / 5,000 = $x / 15,000
3*$x - $36,000 = $x
2*$x = $36,000
$x = $18,000

So, Breakeven EBIT is $18,000

Answer c.

Plan I and All-equity:

Let breakeven EBIT be $x

Plan I:

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $6,000) / 10,000

Plan II:

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $12,000) / 5,000

EPS Plan I = EPS Plan II
($x - $6,000) / 10,000 = ($x - $12,000) / 5,000
$x - $6,000 = 2*$x - $24,000
$x = $18,000

So, Breakeven EBIT is $18,000

Answer d-1.

Answer d-2.

Plan I and All-equity:

Let breakeven EBIT be $x

Plan I:

EPS = (EBIT - Interest Expense) * (1 - tax) / Number of shares
EPS = ($x - $6,000) * (1 - 0.40) / 10,000
EPS = ($x - $6,000) * 0.60 / 10,000

All Equity Plan:

EPS = (EBIT - Interest Expense) * (1 - tax) / Number of shares
EPS = ($x - $0) * (1 - 0.40) /15,000
EPS = $x * 0.60 / 15,000

EPS Plan I = EPS all Equity Plan
($x - $6,000) *0.60 / 10,000 = $x * 0.60 / 15,000
3*$x - $18,000 = 2*$x
$x = $18,000

So, Breakeven EBIT is $18,000

Plan II and All-equity:

Let breakeven EBIT be $x

Plan II:

EPS = (EBIT - Interest Expense) * (1 - tax) / Number of shares
EPS = ($x - $12,000) * (1 - 0.40) / 5,000
EPS = ($x - $12,000) * 0.60 / 5,000

All Equity Plan:

EPS = (EBIT - Interest Expense) * (1 - tax) / Number of shares
EPS = ($x - $0) * (1 - 0.40) /15,000
EPS = $x * 0.60 / 15,000

EPS Plan I = EPS all Equity Plan
($x - $12,000) *0.60 / 5,000 = $x *0.60 / 15,000
3*$x - $36,000 = $x
2*$x = $36,000
$x = $18,000

So, Breakeven EBIT is $18,000

Answer d-3.

Plan I and All-equity:

Let breakeven EBIT be $x

Plan I:

EPS = (EBIT - Interest Expense) * (1 - tax) / Number of shares
EPS = ($x - $6,000) * (1 - 0.40) / 10,000
EPS = ($x - $6,000) * 0.60 / 10,000

Plan II:

EPS = (EBIT - Interest Expense) * (1 - tax) / Number of shares
EPS = ($x - $12,000) * (1 - 0.40) / 5,000
EPS = ($x - $12,000) * 0.60 / 5,000

EPS Plan I = EPS Plan II
($x - $6,000) * 0.60 / 10,000 = ($x - $12,000) *0.60 / 5,000
$x - $6,000 = 2*$x - $24,000
$x = $18,000

So, Breakeven EBIT is $18,000