Question

Break-Even EBIT and Leverage Coldstream Corp. is comparing two different capital structures. Plan I would result in 3,700 shares of stock and $13,700 in debt. Plan II would result in 3,100 shares of stock and $30,140 in debt. The interest rate on the debt is 7 percent.

a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $7,600. The all-equity plan would result in 4,200 shares of stock outstanding. Which of the three plans hast the highest EPS? The lowest?

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Is one higher than the other? Why?

c. Ignoring taxes, when will EPS be identical for Plans I and II?

d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 40 percent. Are the break-even
levels of EBIT different from before? Why or why not?

Answer 1

PART (a)

Computation of EPS

Particulars	Plan I	Plan II	All equity plan
EBIT	7600	7600	7600
Interest (Debt x Rate)	959	2109.8	-
EBT (EBIT - Interest) (A)	6641	5490.2	7600
Outstanding shares (B)	3700	3100	4200
EPS (A / B)	1.79	1.77	1.81
		LOWEST	HIGHEST

PART (b)

Computation of break-even EBIT between All equity plan and Plan I

Computation of break-even EBIT between All equity plan and Plan II

The break-even EBIT is same in both the instances because of the absence of tax. It is an example of M&M Proposition I without taxes.

PART (c)

Computation of break-even EBIT between Plan I and Plan II

EPS of Plan I and Plan II will be equal when EBIT is 8055.6

PART (d)

Computation of EPS

Particulars	Plan I	Plan II	All equity plan
EBIT	7600	7600	7600
Interest (Debt x Rate)	959	2109.8	-
EBT (EBIT - Interest)	6641	5490.2	7600
Tax @40%	2656.4	2196.08	3040
EAT (EBT - Tax) (A)	3984.6	3294.12	4560
Outstanding shares (B)	3700	3100	4200
EPS (A / B)	1.08	1.06	1.09

Computation of break-even EBIT between All equity plan and Plan I

Computation of break-even EBIT between All equity plan and Plan II

Computation of break-even EBIT between Plan I and Plan II

The break-even EBIT is still the same after tax in all plans because the income is being reduced in the same proportion in all plans.