Question

3. Square Block Company 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 350,000 shares of stock outstanding. Under Plan II, there would be 225,000 shares of stock outstanding and $5 million in debt outstanding. The interest rate on the debt is 10 percent, and there are no taxes.

      a.         If EBIT is $1,000,000, which plan will result in the higher EPS?

      b.         If EBIT is $1,500,000, which plan will result in the higher EPS?

      c.         What is the break-even EBIT?

Answer 1

a) Plan 1

EBIT = $1,000,000

Since there is no debt, so there is no interest. Also there are no taxes

So , earnings avaliable to shareholders = $ 1,000,000

  shares of stock outstanding = 350,000

EPS = 1,000,000 / 350,000 = 2.857

Plan 2

EBIT = $1,000,000

Debt = 5000000

Interest = 10% * 5000000 = $ 500000

So , EBIT -interest = $ 500000

Earnings avaliable to shareholders = $ 500000

  shares of stock outstanding = 225000

EPS = 500000/ 225000= 2.222

So Plan 1 will give higher EPS

b)

Plan 1

EBIT = $1,500,000

Since there is no debt, so there is no interest. Also there are no taxes

So , earnings avaliable to shareholders = $ 1,500,000

  shares of stock outstanding = 350,000

EPS = 1,500,000 / 350,000 = 4.286

Plan 2

EBIT = $1,500,000

Debt = 5000000

Interest = 10% * 5000000 = $ 500000

So , EBIT -interest = $ 1000000

Earnings avaliable to shareholders = $ 1000000

  shares of stock outstanding = 225000

EPS = 1000000/ 225000= 4.444

So Plan 2 will give higher EPS

c)

Let the breakeven EBIT be 'x'

So,

In breakeven EBIT both EPS for plan 1 and 2 will be same

So,

x / 350000 = ( x - 500000) / 225000

Solving for x , x= 1400000

Breakeven EBIT = $ 1400000