Question

Destin Corp. is comparing two different capital structures. Plan I would result in 10,000 shares of stock and $90,000 in debt. Plan II would result in 7,600 shares of stock and $198,000 in debt. The interest rate on the debt is 10 percent.

  

a.	Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $48,000. The all-equity plan would result in 12,000 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

$

Answer 1

Solutions to above questions are:

  DESTIN CORP.

(a)

Particulars	Plan I	Plan II	All Equity
EBIT (A)	$48,000	$48,000	$48,000
Debts	$90,000	$198,000	$0
Interest Rate on debt	10%	10%	10%
Interest Amount (B)	$9,000	$19,800	$0
EBT or Net Income (Because tax is to be ignored) (A-B)	$39,000	$28,200	$48,000
No. of Shares	10,000	7,600	12,000
EPS (Net Income / No. of Shares)	$3.90	$3.7105	$4.00

(b) Break Even Levels are as follows :

The break-even level of EBIT for All equity plan as compared to that for Plan I

Formula = (EBIT - Interest Exp. for All Equity Plan) / No. of Shares of All Equity Plan = (EBIT - Interest Exp. for Plan I) / No. of Shares of Plan I

(*in formula, taxes have been ignored)

= (EBIT - 0) / 12,000 = (EBIT - $9,000) / 10,000

= EBIT / 12,000 * 10,000 = (EBIT - $9,000)

= 0.83 EBIT = (EBIT - $9,000)

= EBIT = $9,000 / ( 1 - 0.83)

= $54,000

The break-even level of EBIT for All equity plan as compared to that for Plan II

Formula = (EBIT - Interest Exp. for All Equity Plan) / No. of Shares of All Equity Plan = (EBIT - Interest Exp. for Plan II) / No. of Shares of Plan II

= (EBIT - 0) / 12,000 = (EBIT - $19,800) / 7,600

= EBIT / 12,000 * 7,600 = (EBIT - $19,800)

= 0.63 EBIT = (EBIT - $19,800)

= EBIT = $19,800 / ( 1 - 0.63)

= $54,000

(c) At Following level of EBIT, EPS will be identical for Plans I and II :

Formula = (EBIT - Interest Exp. for Plan I) / No. of Shares of Plan I = (EBIT - Interest Exp. for Plan II) / No. of Shares of Plan II

= (EBIT - $9,000) / 10,000 = (EBIT - $19,800)/ 7,600

= (EBIT - $9,000) / 10,000 * 7,600 = (EBIT - $19,800)

= 0.76EBIT - $6,840 = EBIT - $19,800

= 0.24EBIT = $19,800 - $6,840

= EBIT = 12,960 / 0.24

= $54,000

(d) (1) Assuming that the corporate tax rate is 40 percent, EPS will be computed as under :

Particulars	Plan I	Plan II	All Equity
EBIT (A)	$48,000	$48,000	$48,000
Debts	$90,000	$198,000	$0
Interest Rate on debt	10%	10%	10%
Interest Amount (B)	$9,000	$19,800	$0
EBT	$39,000	$28,200	$48,000
Tax Rate	40%	40%	40%
Tax Expenses ( EBT * Tax Rate)	$15,600	$11,280	$19,200
Net Income	$23,400	$16,920	$28,800
No. of Shares	10,000	7,600	12,000
EPS (Net Income / No. of Shares)	$2.34	$2.226	$2.40

(d) (2) Assuming that the corporate tax rate is 40 percent, Break Even EBIT of each compared with All Equity will be :

The break-even level of EBIT for All equity plan as compared to that for Plan I

Formula = (EBIT - Interest expense for All Equity Plan) * ( 1 - Tax rate) / No. of shares for All Equity Plan = (EBIT - Interest expense for Plan I) * ( 1- Tax rate ) / No. of shares for Plan I

= EBIT - 0) * ( 1 - 40%) / 12,000 = (EBIT - $9,000) * ( 1 - 40%) / 10,000

= EBIT / 12,000 * 10,000 = (EBIT - $9,000)

= 0.83 EBIT = (EBIT - $9,000)

= EBIT = $9,000 / ( 1 - 0.83)

= $54,000

The break-even level of EBIT for All Equity plan as compared to that for Plan II

Formula = (EBIT - Interest expense for All Equity Plan) * ( 1 - Tax rate) / No. of shares for All Equity Plan = (EBIT - Interest expense for Plan II) * ( 1- Tax rate ) / No. of shares for Plan II

= (EBIT - 0) * ( 1 - 40%) / 12,000 = (EBIT - $19,800) * ( 1 - 40%) / 7,600

= EBIT / 12,000 * 7,600 = (EBIT - $19,800)

= 0.63 EBIT = (EBIT - $19,800)

= EBIT = $19,800 / ( 1 - 0.63)

= $54,000

(d) (3) Assuming that the corporate tax rate is 40 percent, EPS will be identical for Plan I and Plan II at the following level of EBIT :

Formula = (EBIT - Interest expense for Plan I) * ( 1 - Tax rate) / No. of shares for Plan I = (EBIT - Interest expense for Plan II) * ( 1- Tax rate ) / No. of shares for Plan II

= (EBIT - $9,000) * ( 1 - 40%) / 10,000 = (EBIT - $19,800) * (1 - 40%) / 7,600

= (EBIT - $9,000) / 10,000 * 7,600 = (EBIT - $19,800)

= 0.76EBIT - $6,840 = EBIT - $19,800

= 0.24EBIT = $19,800 - $6,840

= EBIT = 12,960 / 0.24

= $54,000

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