Question

Create an Excel spreadsheet to organize your answers to the following problem, and submit your Excel file as an attachment by clicking on the appropriate button on this page.

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:
	Alt first	Alt second
EBIT	6000000	6000000
Less: Interest expense	-2000000	-3800000
EBT	4000000	2200000
Less: Tax expense	1400000	770000
NI	2600000	1430000
Outstanding shares	1000000	750000
EPS	2.6	1.91
part 2:
	Alt first	Alt second
EBIT (increase by 20%)	7200000	7200000
Less: Interest expense	-2000000	-3800000
EBT	5200000	3400000
Less: Tax expense	1820000	1190000
NI	3380000	2210000
Outstanding shares	1000000	750000
EPS	3.38	2.95
part 3:
	Alt first	Alt second
EBIT (decrease by 20%)	4800000	4800000
Less: Interest expense	-2000000	-3800000
EBT	2800000	1000000
Less: Tax expense	980000	350000
NI	1820000	650000
Outstanding shares	1000000	750000
EPS	1.82	0.87
Part 4)
EBIT/EPS	6M/2.6	6M/1.91
	2307692	3141361
Part 5)
The higher the EBIT, the less the effect of interest and taxes and EPS will increase.
The lower the EBIT, the more the effect of interest and tax rates, thus EPS will decrease rapidly.