Question

Your firm is considering two financing plans. The key information

            follows: use a 20% tax rate.

            Source of Funds                      Plan A                         Plan B

            Long-term Debt                      $1000 at 6%                $5000 at 10%

            Preferred Stock                       100 shares, $2             20 shares, $2

                                                            dividend per share      dividend per share

            Common Stock                       120 shares                   30 shares

            --------------------------------------------------------------------------------------

                        Draw the EPS-EBIT line for each plan on the same set of axes. Over what range of EBIT would you prefer Plan A?

Answer 1

Given Information –

Tax Rate (T) = 20%

Source of Funds                            Plan A                         Plan B

Long-term Debt                      $1000 at 6%              $5000 at 10%

Preferred Stock                       100 shares, $2             20 shares, $2

                                                            dividend per share      dividend per share

Common Stock                       120 shares                   30 shares

Formula for EPS –

EPS = ((EBIT – Interest Expense) * (1-Tax Rate) – Preferred Dividend) / (No of Common shares outstanding)

So, EPS_A = ((EBIT – 1000 * 6%) * (1 - 0.2) – 100 *2) / 120 = ((EBIT – 60) * 0.8 – 200) / 120

EPS_B = ((EBIT – 5000 * 10%) * (1 - 0.2) – 20 *2) / 30 = ((EBIT – 500) * 0.8 – 40) / 30

Plotting the respective equations, we get the following ( or as attached) graph –

Interesection point where EPS_A = EPS_B is at EBIT = $630

Below $630 of EBIT one would prefer Plan A

We can also get the answer by solving the equation EPS_A = EPS_B