Question

Create an Excel spreadsheet to organize your answers to the following problem.

A company with EBIT of $6,000,000 is considering two financing alternatives. The first alternative would have $25 million of bonds at 8% interest and 1,000,000 common shares outstanding, whereas the second would have $47.5 million of bonds at 8% interest and 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		Part 2		Part C
	Particulars	Alternative - I	Alternative - II	Alternative - I	Alternative - II	Alternative - I	Alternative - II
	EBIT	6,000,000	6,000,000	7,200,000	7,200,000	4,800,000	4,800,000
Less:	Interest Expense	2,000,000	3,800,000	2,000,000	3,800,000	2,000,000	3,800,000
	EBT	4,000,000	2,200,000	5,200,000	3,400,000	2,800,000	1,000,000
Less:	Tax Expense @ 35%	1,400,000	770,000	1,820,000	1,190,000	980,000	350,000
	Earning after Tax	2,600,000	1,430,000	3,380,000	2,210,000	1,820,000	650,000
	No. of Stock	1000000	750000	1000000	750000	1000000	750000
	EPS	2.6000	1.9067	3.3800	2.9467	1.8200	0.8667

Part 4: EBIT/EPS Indifference Point  

(( X - 20,00,000) *(1-0.35) )/10,00,000 = (( X - 38,00,000) *(1-0.35) )/750000

(0.65X - 1300,000) /100 = (0.65X -24,70,000)/75

48.750 X - 975,00,000 = 65 X - 24,70,00,000

= 149500000 = 16.25 X

X = 9200,000

At EBIT 92,00,000 , EPS per share is same under both alternative.

Part 5 :- Based on the above result, if company has low EBIT, then company shall not raised funds from bonds because of company's low ability to pay the debt . Breakeven point for both alternative 9200,000 EBIT .   

If we saw if Part C, Company EBIT is 4800,000, if company raise more bond company i.e. Alternative - II left with very little amount i.e. 650,000 to pay to the stock holder but if company choose alternative - I i.e. company raise more funds from equity and less from bond then company left with 1820,000 for shareholder i.e. 1.820 EPS in comparison to 0.8667 EPS in Alternative II