Question

A company with EBIT of $6,000,000 is considering two financing alternatives. The first alternative would have interest expense of $2,000,000 and 1,000,000 common shares outstanding, whereas the second would have interest expense of $3,800,000 but only 750,000 shares outstanding. The company is in the 35% tax bracket.

Part 1: Construct the bottom half of the income statement (including EPS) for each financing alternative when EBIT is at $6,000,000.

Part 2: Construct the bottom half of the income statement (including EPS) for each alternative if EBIT increases by 20%.

Part 3: Construct the bottom half of the income statement (including EPS) for each alternative if EBIT decreases by 20%.

Part 4: What is the EBIT/EPS indifference point for this firm?

Part 5: Comment on the results of your calculations above. What principle does this exercise demonstrate?

Answer 1

Part 1 - Part 3 ( Shown in table below)

Alternative 1
	Normal	EBIT = Up by 20%	EBIT = down by 20%
EBIT	6000000	7200000	4800000
Interest	2000000	2000000	2000000
EBT	4000000	5200000	2800000
Tax@35%	1400000	1820000	980000
Net Profit	2600000	3380000	1820000
No fo Shares	1000000	1000000	1000000
EPS	2.60	3.38	1.82
Change in EPS		30.00%	-30%
Alternative 2
	Normal	EBIT = Up by 20%	EBIT = down by 20%
EBIT	6000000	7200000	4800000
Interest	3800000	3800000	3800000
EBT	2200000	3400000	1000000
Tax@35%	770000	1190000	350000
Net Profit	1430000	2210000	650000
No fo Shares	750000	750000	750000
EPS	1.91	2.95	0.87
Change in EPS		54.55%	-55%

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Point of indifference for EBIT means, in both the casesEPS will be same. Assume EBIT will be x

EPS for alternative 1 = EPS of alternative 2

(x-2000000)x(1-.35)/1000000 = (x - 3800000)x(1-.35)/750000

Solving for X = 9200000

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2nd option is riskier than option 1. SInce, at good time 2nd alternative will give you higher EPS growth,. But in bad times, EPS degrowth will also be higher.