Question

Aant Investments Inc. currently has $3.5 million in debt outstanding, bearing in interest rate of 12.3%. It wishes to finance a $5 million expansion program and is considering five alternatives.

Plan	Debt	Preferred	Equity
1	0%	0%	100%
2	35%	0%	65%
3	50%	0%	50%
4	50%	20%	30%
5	60%	20%	20%

The preferred stock dividend will be 12% and the price of common stock will be $18 per share. The company currently has 750,000 shares of common stock outstanding and is in 40% tax bracket.

1) If the earnings before interest and taxes are $1.5 million, what would be earning per share for five alternatives, assuming no immediate increase in the operating profit.

2) Compute the degree of financial leverage (DFL) for each alternatives at the expected EBIT level of $1.5 million.

3) Which alternative do you prefer and why?

Answer 1

1) EPS in each plan

Plan	EBIT (in million)	Interest(in million)	EBT(in million	EAT(in million)	Preference dividend(in million)	Number of shares	EPS
1	$1.50	$0.43	$1.07	$0.64		10,27,777.78	$0.62
2	$1.50	$0.65	$0.85	$0.51		9,30,555.56	$0.55
3	$1.50	$0.74	$0.76	-$0.02		8,88,888.89	-$0.03
4	$1.50	$0.74	$0.76	-$0.02	$0.12	8,33,333.33	-$0.17
5	$1.50	$0.80	$0.70	$0.10	$0.12	8,05,555.56	-$0.03

Formulas used:
i) Number of shares of equity = 750000 + (($5000000*equity % in financing)/price per share)

ii) Interest = (5*12.3%) + (5000000*debt % financing * 12.3%)

iii) EPS = Total earnings after interest and dividends / total number of ordinary shares

2) Degree of financial leverage = EBIT / EBT

Plan	EBIT (in million)	EBT(in million	DOFL
1	$1.50	$1.07	1.40
2	$1.50	$0.85	1.76
3	$1.50	$0.76	1.97
4	$1.50	$0.76	1.97
5	$1.50	$0.70	2.14

3) We should go for plan 2 as it has a positive earnings per share and also a higher degree of financila leverage