Question

Case Study 2

Read the case study given below and use your knowledge to answer the questions that follow. Examples are to be provided in places where possible.

EBIT-EPS Analysis and Choice of Capital Structure

The current COVID 19 pandemic showed a huge increase in the demand for Personal Protective Equipment’s (PPE) that included face masks, N95 respirators and medical clothing. Xixian Ltd that specialises in production of N95 respirators had stocks of the N95 respirators which were all purchased by health departments and people within two weeks after the outbreak of Coronavirus and this taught a lesson to Xixian Limited to produce the N95 respirators in huge amounts for any sudden future needs.

With the current capacity of its manufacturing plants, it is very difficult to produce a high quantity of the respirators so Xixian Limited is now considering to buy a bigger respirator producing plant that would cost them $2 million. This new investment is expected to generate a permanent increase in the earnings before interest and taxes of $400,000 per annum. The current earnings before interest and taxes is $0.8million. Xixian Limited’s current capital structure consists of contracted debt and equity. The company has 0.1 million preference shares which are traded in the market for $16 each and pay a fixed annual dividend of 8%. Xixian Limited’s contracted debt comprises of $1,500,000 of issued bonds that pays 14% per annum. The firm currently has 0.45 million ordinary shares have been issued and are trading at $20 per share. The tax regulation mandates a 25.00% corporate tax rate for Xixian Limited. Required:

a) To fund the acquisition of the new ‘bigger respirator producing plant’ entirely, Xixian Limited can issue new ordinary shares (New Equity Plan) at the current market price. What is the impact on EPS if new shares are issued to fund the expansion?

b) To fund the acquisition of the new ‘bigger respirator producing plant’ entirely, Xixian Limited can raise new debt at 17.00% interest rate (New Debt Plan). What is the impact on EPS of using debt rather than a new equity issue?

c) Calculate the EPS indifference point of New Equity plan and New Debt Plan

d) Comment on the level of Financial Risk of choosing the New Debt Capital structure over the New Equity Capital structure.

Answer 1

a) and b)

The EPS calculations under current plan , New Equity plan and New Debt plan are as shown below

	Current plan	New Equity plan	New Debt plan
Debt	1500000	1500000	3500000
Cost of Debt	210000	210000	550000
No of Equity shares	450000	550000	450000
EBIT	800000	1200000	1200000
Less Interest	210000	210000	550000
EBT	590000	990000	650000
Less Tax	147500	247500	162500
PAT	442500	742500	487500
Less: Preference Dividend	80000	80000	80000
Profit available to common equityholders	362500	662500	407500
EPS	0.805556	1.204545	0.905556

a) It can be seen that New Equity plan increases the EPS from $0.81 to $1.20

b) The New Debt plan increases the EPS from $0.80 to $0.91

c) The EPS indifference point is the EBIT level where EPS for both New Equity plan and New Debt plan is the same

So,EPS for New Equity plan = ((EBIT-210000)*0.75-80000)/550000

EPS for New Debt plan = ((EBIT-550000)*0.75-80000)/450000

So, at Indifference point EBIT level is given by

((EBIT-210000)*0.75-80000)/550000 = ((EBIT-550000)*0.75-80000)/450000

=> 9*(EBIT-210000)*0.75- 9 * 80000 = 11*(EBIT-550000)*0.75 - 11* 80000

=> 2*EBIT*0.75 = 2*80000+ 11*550000*0.75-9*210000*0.75

=> 1.5* EBIT = 3280000

=> EBIT = $2,186,667

So, at EBIT level indifference point is $2,186,667

d) The New Debt plan will make the total Debt very high ($5.5 million) which will be very risky for the firm as it increases the leverage risk. Thus, very high amount of EBIT ( $2.1866 million) is required to match the same with the New Equity plan. Thus, at the current operating point it is better to stick with the new Equity plan