Question

Hale Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 175,000 shares of stock outstanding. Under Plan II, there would be 125,000 shares of stock outstanding and $2.5 million in debt outstanding. The interest rate on the debt is 8 percent and there are no taxes. a. If EBIT is $650,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) EPS Plan I $ Plan II $ b. If EBIT is $900,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) EPS Plan I $ Plan II $ c. What is the break-even EBIT? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.) Break-even EBIT $

Answer 1

Capital structure (CS) is the structure of dabt and equity. It determines how a firm finances its business. There are two major component of CS. first is equity shares. Shareholders are the owner of the company. They are entitled for theri share in profit as percentage of capital invested by them

Second is debt. debtholders are the creditors for the company. They are entitled for an interest payment at the fixed percentage on their debt-amount. This interestr is a deductible expense from the taxable income.

1> EPS is earning per share which determined by dividing the number of outstanding shares from earnings after tax. It will be calculated as below when EBIT is $650,000:-

Thus, EPS of plan 1 is 3.714 and plan 2 is 3.60.

2> when EBIT is $900,000, EPS will be calculated as below:-

In this case, EPS in plan 1 is 5.143 and plabn 2 is 5.6.

3> Break even EBIT is the level of EBIT where EPS of the comopany reamins same irrespective of its capital-structure. It means , EPS will not change with the change in debt or equity. It is calculateds as below:

Plan 1 where no debt is used:-

here, N1 is number of otstanding shares or 175,000

Plan 2: where debt of 2,500,000 is used:

  

where interest is 8% on 2.5 million debt and N2 is 125,000.

Step 2: Equate the above both equations. beacause EPS will remain same for both plans.

Step 3: By cross multiplication, solve the above equation:

Thus, Break even EBIT is $700,000 where EPS will remain same irrespective of its capital structure.