Question

Based on the following set of information, do an EPS-EBIT analysis

There is 100% debt, 70% debt and 30% equity, 50% debt and 50% equity, 30% debt and 70% equity, and 100% equity. The amount of capital needed is $100 million.

The estimated range is low: $20 million, middle: $30 million, high $40 million.

IR= 5%

Tax rate= 30%

Stock price= $50

# of shares outstanding= 500 million

Answer 1

EPS-EBIT Analysis Formula

Formula :

(EBIT - IA)(1 - T) - PDA
SA

where

EBIT – earnings before interest and taxes

I_A – interest expense in financing plan A

T – corporate income tax rate

PD_A – preferred dividends payable in financing plan A

S_A – amount of common stock outstanding in financing plan A

The best plan is where the EBIT is lower but the EPS is higher. Hence we will compute the financial breakeven point for each plan

The Financial Breakeven point is where the EPS is 0

Plan 1 (100% Equity)

(EBIT-0)(1-0.3) -0 =0

502

Breakeven EBIT : 0Mio

Plan 2 (100% debt)

(EBIT-5)(1-0.3) -0 =0

500

Breakeven EBIT : 5Million

Plan 3 (70% debt and 30% Equity)

(EBIT-3.5)(1-0.3)-0   =0

500.6

Breakeven EBIT : 3.5Mio

Plan 4 (50% debt and 50% Equity)

(EBIT-2.5)(1-0.3)-0   =0

501

Breakeven EBIT : 2.5Mio

Plan 5 (30% debt and 70% Equity)

(EBIT-1.5)(1-0.3)-0   =0

501.4

Breakeven EBIT : 1.5Mio

As per the above analysis the best option is to do 100% equity, second best to do 30% debt and 70%, 3rd Best to 50% debt and 50% equity, 4th best to do 70% debt and 30% equity and least preferable option is 100% debt.