Question

DEF Company is comparing three different capital structures. Plan I would result in 800 shares of stock and $9,000 in debt. Plan II would result in 700 shares of stock and $13,500 in debt. Plan III is an all-equity plan and would result in 1,000 shares of stock. The firm’s EBIT will be $8,000 per year until infinity. The interest rate on the debt is 10%.

a. Ignoring taxes, compute the EPS for each of the three plans. Which of the three plans has the highest EPS? Which has the lowest?                         

b. Compute the break-even EBIT that will cause the EPS on Plan I to be equal to the all-equity EPS.                                                                      

c. Compute the break-even EBIT that will cause the EPS on Plan II to be equal to the all-equity EPS.                                                             

d. Compare your results from parts (b) and (c) above. Is one higher than the other? Why?                                                                            (1 mark)

e. Ignoring taxes, what is the break-even EBIT that will cause the EPS on Plan I to be equal to the EPS on Plan II? What conclusions do you reach when you compare the outcomes of parts (b), (c), and (e) above?                  

Answer 1

Plan I:

Number of shares outstanding = 800
Value of Debt = $9,000

Interest Expense = 10%*$9,000
Interest Expense = $900

Plan II:

Number of shares outstanding = 700
Value of Debt = $13,500

Interest Expense = 10%*$13,500
Interest Expense = $1,350

All Equity Plan:

Number of shares outstanding = 1,000

Answer a.

Plan III has lowest EPS and Plan II has highest EPS.

Answer b.

Let breakeven EBIT be $x

EPS, Plan I = ($x - $900) / 800

EPS, Plan III = ($x - $0) / 1,000

EPS, Plan I = EPS, Plan III
($x - $900) / 800 = $x / 1,000
10*$x - $9,000 = 8*$x
2*$x = $9,000
$x = $4,500

So, breakeven EBIT is $4,500

Answer c.

Let breakeven EBIT be $x

EPS, Plan II = ($x - $1,350) / 700

EPS, Plan III = ($x - $0) / 1,000

EPS, Plan II = EPS, Plan III
($x - $1,350) / 700 = $x / 1,000
10*$x - $13,500 = 7*$x
3*$x = $13,500
$x = $4,500

So, breakeven EBIT is $4,500

Answer d.

Breakeven EBIT in parts (b) and (c) are equal

Answer e.

Let breakeven EBIT be $x

EPS, Plan I = ($x - $900) / 800

EPS, Plan II = ($x - $1,350) / 700

EPS, Plan I = EPS, Plan II
($x - $900) / 800 = ($x - $1,350) / 700
7*$x - $6,300 = 8*$x - $10,800
$x = $4,500

So, breakeven EBIT is $4,500

Breakeven EBIT in parts (b), (c) and (e) are equal