Question
In: Finance
Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount drug chain store business. The...
Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Lenow and Hall are presented here.
| Lenow | Hall | |||||
| Debt @ 8% | $ | 300,000 | Debt @ 8% | $ | 600,000 | |
| Common stock, $10 par | 600,000 | Common stock, $10 par | 300,000 | |||
| Total | $ | 900,000 | Total | $ | 900,000 | |
| Common shares | 60,000 | Common shares | 30,000 | |||
a. Complete the following table given earnings
before interest and taxes of $34,000, $72,000, and $89,000. Assume
the tax rate is 10 percent. (Negative amounts should be
indicated by parentheses or a minus sign. Round
your answers to 2 decimal places.)
b-1. What is the EBIT/TA rate when the firm's have
equal EPS?
b-2. What is the cost of debt?
b-3. State the relationship between earnings per
share and the level of EBIT.
c. If the cost of debt went up to 10 percent and
all other factors remained equal, what would be the break-even
level for EBIT?
Solutions
Expert Solution
| a) | What is the relationship | |||||||
| EBIT | Total Assets | EBIT/TA | Lenow EPS | Hall EPS | of the two firms | |||
| 34000 | 900000 | 3.78% | $ 0.15 | $ -0.47 | Lenow > Hall | |||
| 72000 | 900000 | 8.00% | $ 0.72 | $ 0.72 | Lenow = Hall | |||
| 89000 | 900000 | 9.89% | $ 0.98 | $ 1.23 | Lenow < Hall | |||
| CALCULATION OF EPS: | ||||||||
| LENOW: | ||||||||
| EBIT | Interest | EBT | Tax at 10% | NI | # of shares | EPS | ||
| 34000 | 24000 | 10000 | 1000 | 9000 | 60000 | $ 0.15 | ||
| 72000 | 24000 | 48000 | 4800 | 43200 | 60000 | $ 0.72 | ||
| 89000 | 24000 | 65000 | 6500 | 58500 | 60000 | $ 0.98 | ||
| HALL: | ||||||||
| EBIT | Interest | EBT | Tax at 10% | NI | # of shares | EPS | ||
| 34000 | 48000 | -14000 | 0 | -14000 | 30000 | $ -0.47 | ||
| 72000 | 48000 | 24000 | 2400 | 21600 | 30000 | $ 0.72 | ||
| 89000 | 48000 | 41000 | 4100 | 36900 | 30000 | $ 1.23 | ||
| b-1) | EBIT/TA rate for equal EPS = 8% | |||||||
| b-2) | Cost of debt = 8% | |||||||
| b-3) | EPS is unaffected by financial leverage when the pre-tax returns on assets (EBIT/TA) equals the cost of debt. | |||||||
| c) | Breakeven EBIT is where the EPS of the two firms are equal. | |||||||
| EPS for Lenow = (E-24000)*90%/60000 | ||||||||
| EPS for Hall = (E-48000)*90%/30000 | ||||||||
| where E = the break even EBIT | ||||||||
| Equating the two EPS | ||||||||
| (E-24000)*90%/60000 = (E-48000)*90%/30000 | ||||||||
| Solving for E | ||||||||
| (E-24000) = 2*(E-48000) | ||||||||
| E-24000 = 2*E - 96000 | ||||||||
| E = 72000 | ||||||||
| Breakeven EBIT = $24000 | ||||||||
| CHECK: | ||||||||
| Lenow | Hall | |||||||
| EBIT | 72000 | 72000 | ||||||
| Interest | 24000 | 48000 | ||||||
| EBT | 48000 | 24000 | ||||||
| Tax at 10% | 4800 | 2400 | ||||||
| NI | 43200 | 21600 | ||||||
| # of shares | 60000 | 30000 | ||||||
| EPS | $ 0.72 | $ 0.72 | ||||||
jeff jeffy answered 1 year agoRelated Solutions
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